A brief history of the Australian discounted cash flow practice standard
| Pages | 196-211 |
| DOI | https://doi.org/10.1108/14635780010324349 |
| Published date | 01 April 2000 |
| Date | 01 April 2000 |
| Author | David Parker,Jon Robinson |
| Subject Matter | Property management & built environment |
JPIF
18,2
196
Journal of Property Investment &
Finance, Vol. 18 No. 2, 2000, pp. 196-
211. #MCB University Press,
1463-578X
CONFERENCE PAPERS
A brief history of the
Australian discounted cash
flow practice standard
David Parker
Manager Property Investments, Suncorp Investments, Brisbane,
Queensland, Australia, and
Jon Robinson
Faculty of Architecture Building and Planning,
The University of Melbourne, Australia
Keywords Investment property, Valuation, Standards
Abstract The increasing complexity of investment properties has necessitated the application of
more advanced valuation and analysis techniques. Following the property cycle of the 1980s/
1990s, and the recommendations of several reporters, the DCF method has been promoted in
Australia for certain income-producing properties. The Australian Property Institute
disseminated an information paper in 1993 that discussed DCF and suggested a performance
approach to its application. Following this, a practice standard was produced in 1996 that was
highly prescriptive but which contained a number of confusing passages. With the benefit of
hindsight, its publication was premature and it was withdrawn from circulation. A rewrite was
commissioned and an exposure draft was circulated in early 1999. It has been prepared as a
performance standard in which the valuer is called on to follow a method while disclosing the
specifics. However, a number of considerations remain to be finalised, for example, the
application of the term cash flow to net operating income, income after finance and income after
finance and tax. The preparation of standards is an evolutionary process and the present
coverage of the DCF practice standard reflects the market in which it applies.
1. Introduction
Investment property and property capable of returning financial flows is
traditionally valued by the income approach. This traditional process requires
that the valuer computes the annual net operating income and capitalises it by
the application of a capitalisation rate derived from the analysis of comparable
market sales evidence. The capitalised net operating income is the present
value of the investment stream expected to be derived from the property into
the future. Thus the investment stream has been discounted. This traditional
approach is a real cost approach. No allowance is made for inflationary factors
such as rental growth and this is reflected in the adoption of a real
capitalisation rate. This process is ideal for single user properties. Only two
variables are required to complete the valuation.
Over the past two decades, the complexity of property developments and
investments has grown substantially. Large multi-tenanted properties contain
individual lessees where leases have been agreed on many different bases in
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Conference papers:
Discounted cash
flow practice
197
respect of rent reviews and outgoings recoveries. Thus a single property can
have leases with different rent review cycles, net and gross leases, leases with
reviews to market rental values or to a specified index, with and without caps
and collars, and leases in which rentals have been agreed at different stages in
the property market cycle. The application of an appropriate capitalisation rate
to such a variable net operating income is no longer practical given the
unlikelihood of obtaining directly comparable evidence. Valuers have turned to
the financial market for methodologies that are applicable in these
circumstances where each lease needs to be separately modelled. The process
that has been adopted is discounted cash flow (DCF). It involves the projection
of net operating income for a period of years (usually ten years) at the
termination of which a hypothetical disposal of the property takes place. In
Australia, the financial flows are normally on a before interest and tax basis
(i.e. earnings before interest and tax). True DCF should be undertaken on an
after interest and after tax basis, but as interest rates and tax rates can vary
from entity to entity, the outcome is usually construed as being an investment
valuation rather than a market valuation. The DCF process requires the
combination of many variables.
The many variables and assumptions required for DCF analysis, combined
with different ways of allocating them on a time scale, led to a significant
number of combinations and permutations and, ultimately, a lack of trust in the
results. As a result of this, the then Australian Institute of Valuers and Land
Economists (AIVLE) resolved to standardise the methodology. The evolution
of the guidance on DCF provided to its members by the Australian Property
Institute (API or the ``Institute'') and its predecessor bodies (being the
Australian Institute of Valuers (AIV), Australian Institute of Valuers and Land
Administrators (AIVLA) and AIVLE) mirrors the evolution of the property
market in Australia over the last 20 years.
While the following does not seek to provide a comprehensive chronology, it
serves to illustrate the changes in the property market, the gradual
acceptability of DCF as a valuation method and the corresponding change in
the approach of the Institute to its codification over the period. The purpose of
this paper is to describe the various attempts at standardisation leading up to
the current (1999) draft Practice Standard and its associated Guidance Note.
First, the early history is discussed in the context of the need for a Standard in
the face of the 1980s/1990s property cycle. Second, the reaction of the
profession is outlined which led to the Institute's 1993 Information paper.
Third, the 1996 Standard is broadly outlined together with reasons for its
review. Fourth, the principles of the 1999 draft are discussed and the content is
outlined. Finally, some suggestions for future development of DCF process and
standard are provided.
The popular term discounted cash flow is used throughout this paper to
refer to the discounted financial flows whether they are before interest and tax
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