What is a discounted cash flow (DCF)?
- Projects estimated cash flows over an assumed investment holding period, plus an exit value at the end of that period, usually arrived at on a conventional ARY basis
- Cash flow is then discounted back to the present day at the discount rate (also known as desired rate of return) that reflects the perceived level of risk
- Growth explicit investment method of valuation
In what circumstances are you likely to use a DCF?
- Short leasehold interests and properties with income voids or complex tenures
- Phased development projects
- Some ‘Alternative’ investments with limited comparable evidence
- When comparing returns from real estate to returns from other asset classes
- Non-standard investments (e.g. with 21-year rent reviews)
- Over rented properties
- Social housing
What guidance did the RICS issue on the use of the DCF method?
RICS Discounted cash flow for commercial property investments, 2010
How would you calculate the value of a property using the DCF method?
- Estimate the cash flow (income less expenditure)
- Estimate the exit value at the end of the hold period
- Select a discount rate
- Discount cash flow at the discount rate
- Sum of the discounted cash flows would provided you with the NPV, which is the value of the property
What is the net present value (NPV)?
Sum of all future expected income and capital flows, discounted at the investor’s required rate of return
Where you have a known purchase price, what does it mean if there is a positive NPV?
Investment exceeds the investor’s target rate of return
Where you have a known purchase price, what does it mean if there is a negative NPV?
Investment has not achieved the investor’s target rate of return
What is the internal rate of return (IRR)?
The rate of return which all future cash flows must be discounted at to produce an NPV of zero
What can a valuer use if they don’t have a software package to calculate the IRR?
- Linear interpolation can be used to estimate the IRR
* Find a discount rate which produces a negative and positive NPV, then interpolate between the two
According to Discounted Cash Flow for Commercial Property Investments, 2010), what does Investment Value describe?
Investment Value describes what a property is worth to a specific investor, based on their assumptions about the future expected income from that property
How does the relationship between Investment Value and Market value influence an investors decision to buy/sell?
- All things being equal, it should hold that, if Market Value is Lower than Investment Value, an investor will take the decision to acquire a property
- Likewise, if Market Value is greater than the Investment Value, the investor will take the decision to sell
Why might an investor’s opinion on Investment Value differ from the Market Value?
Because each individual investor has different income requirements, expectations of where the market will move, attitudes to risk, tax positions etc.
What is the discount rate also known as? What does it reflect?
Discount rate is also known as desired rate of return. It reflects the perceived level of risk
What must you take care not to do when selecting a discount rate?
You must take care not to double count, meaning that if the discount rate has made allowances for a factor implicitly, you should not then make cost allowances explicitly for that factor in the cash flow too
When modelling the expected revenue flows (rental income) from a real estate asset, what factors must you consider?
- Rent reviews or indexations (OMRR, Geared to CPI/RPI, Stepped Rents)
- Void periods in between leases
- Rent Free Period
- Tenant Incentives (outside of rent free periods, this may include contribution to fitout costs)
- Non-Recoverable Costs (Utilities, Rate Liabilities, security)
- Typical Lease Length for new leases (including break options)
What might you use to give you an indication of the void costs for a property?
The service charge accounts (plus the non-recoverable element if applicable)
What is the difference between a property level cash flow and a fund level cash flow?
Property Management and Asset Management fees are usually accounted for in a Fund Level Cash Flow. This is specific to each investor however, and will depend on the objective of your client
What should you consider when choosing your Exit Yield?
The business plan for the property, and therefore:
- WALT at exit (e.g. if you have a six year lease and you run a five year cash flow, you are selling with one year remaining)
- Market at exit (Yield compression, any improvement in the location)
- Quality of the asset at exit (Are you spending money during the cash flow to refurbish? How old will the building be at the end of the cash flow)
- Occupancy at exit (will you be 100% occupied when you sell the property)
What timeframe do Cash flows normally cover? What must you consider when setting this?
Cash flows are traditionally of 5, 10 or 15 years. In practice, +10 year cash flows are less common, because the accuracy of assumptions employed is diminished over a longer period. The valuer needs to consider lease expiries, the fund life, desired hold period and return targets when targeting an exit date
How do you calculate your PV Factor from the discount rate?
The Discount Factor = 1/((1+r)^n)
r = discount rate n = years
What is the sum of all discounted cash flows called?
Net Present Value
How is IRR calculated (even by Excel)?
Interpolative trial and error, excel just does this really fast and behind the formula. You can always sense check the IRR by making sure that at the IRR rate adopted the NPV does equal zero
What is CAPM and what does it say about discount rates?
CAPM is the “Capital Asset Pricing Model”, it splits risk into to two sections: Alpha and Beta
Beta = market or systemic risk
Alpha = risk specific to that asset
These are also used to describe return – returns from market movements are Beta, returns from over performance are described as Alpha
Where would you usually source the risk free rate?
You would typically derive the risk free rate from the gross redemption yields for medium to long term government bonds
When you’re unable to find comparable evidence, what can you base your discount rate on?
- Can use corporate bonds if the property has a long lease or can look at the equities market
- Would be categorised as ‘Category C - other sources’ in RICS Comparable evidence in real estate valuation, 2019
If valuing a property using a DCF where the lease ran to 0, what exit value would you assume?
Would either assume 0 property value at exit, or a negative value depending on the reinstatement clauses in the lease i.e. may require the leaseholder to demolish the property
Can a valuation using the DCF method be Red Book compliant?
Yes, the DCF method of valuation is classified under the ‘Income Approach’ as defined in the IVS 105
How are you able to provide financial modelling advice without being regulated by the FCA?
- Models are at a property level only rather than providing returns at a fund level
- Relate to the acquisition and disposal of specific assets
- Developed in conjunction with the client using their assumptions
- Show the indicative returns based on the assumptions used