Practice Briefing: The implications of a move towards explicit discounted cash flow (DCF) models for property investment valuations
| Date | 28 June 2024 |
| Pages | 380-395 |
| DOI | https://doi.org/10.1108/JPIF-04-2024-0052 |
| Published date | 28 June 2024 |
| Author | Malcolm Frodsham |
Practice Briefing: The implications
of a move towards explicit
discounted cash flow (DCF) models
for property investment valuations
Malcolm Frodsham
Real Estate Strategies, London, UK
Abstract
Purpose –The primarypurpose of thisPractice Briefingis to examine theimplications of therecommendations
of theRoyal Institutionof Chartered Surveyors(RICS) Reviewof Investment Valuationsto shifttowards (explicit)
discountedcash flow (DCF) valuations on valuers,clients, risk managementand market data.
Design/methodology/approach –This Practice Briefing will develop a conceptual framework to articulate
the impact of the shift towards explicit modelling assumptions in valuations. A comparative analysis is
conducted to contrast traditional valuation approaches with an explicit DCF approach.
Findings –The proposed shift to DCF valuations in the real estate industry carries both subtle and profound
implications. While on the surface, the move appears to bring minimal change since current valuations are
already DCF-based, a deeper exploration reveals a potential transformation to the understanding, analysis and
measurement of pricing and risks in commercial real estate.
Practical implications –The traditional techniques adopted in valuations have become pervasive in the
industry, hindering more sophisticated modelling and analysis of individual assets and portfolios. Explicitly
modelling assumptions in both the initial years of cash flow and perpetuity calculations would unveil fundamental
relationships and rationales that have previously been buried within, and perhaps ignored by, an All Risks
Yield (ARY).
Originality/value –This briefing identifies the cause of confusion when interpreting ARY differentials on
implied target returns and risk and demonstrates how a change to explicit assumptions, such as growth and
letting periods, would enhance transparency, enabling more informed client–valuer discussions, which in-turn
will boost confidence in valuation accuracy, lead to more sophisticated asset modelling, market data,
forecasting and market analysis.
Keywords Real estate valuation, Cash flow modelling, Risk, Real estate market data
Paper type Viewpoint
1. Introduction
The Royal Institution of Chartered Surveyors (RICS) Independent Review of Real Estate
Investment Valuations recommends adopting (explicit) Discounted Cash Flow (DCF) as the
primary model for property investment valuations. The recommendation is based on the
idea that explicit adjustments to cash flow projections, considering factors like growth,
costs and vacancies, would enhance the valuation process and deliver better value to
clients.
What is apparent is that clients are becoming less accepting of ‘implicit’valuation inputs,
assumptions, and outcomes within the method and models used; instead, the models should be
‘explicit’to achieve the required levels of transparency, understanding, and education. RICS
Independent Review of Real Estate Investment Valuations (RICS, 2022)
In implicit property valuation models, the net present value (NPV) computation involves a
reversion to the current Market Rent based on the terms of the lease. A final cash flow term is
then held in-perpetuity. Impacts on cash flow, especially growth, are implicitly captured in the
capitalisation rate (RICS, 2023), known as the All Risks Yield (ARY). Also captured within the
ARY is a risk premium.
JPIF
42,4
380
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1463-578X.htm
Journal of Property Investment &
Finance
Vol. 42 No. 4, 2024
pp. 380-395
© Emerald Publishing Limited
1463-578X
DOI 10.1108/JPIF-04-2024-0052
Making the growth and risk premium assumptions explicit would not necessarily change
the valuation result but would enhance transparency and understanding of the underlying
assumptions driving the valuation.
This briefing firstly considers the mechanics of the calculation of net present value (NPV)
implicitly and explicitly, starting with a basic scenario of cash flows following a regular
pattern and sequentially introducing complicating factors.
1.1 Worth (Investment Value)
The Worth [1] of any asset can be determined by the NPV of the expected future cash flow,
discounted at the investor’s target return. The buy/sell decision is whether the calculation of
worth is greater or less than Market Value.
However, rather than an NPV calculation, it is widespread market practice in real estate
for the internal rate of return (IRR) of the property to be estimated using a start value, plus a
series of net cash flows (based on explicit assumptions) and an exit valuation (RICS, 2023,
para 2.1). The buy/sell decision is then whether the IRR is greater or less than the target
return. The IRR approach will (almost always) give the same buy/sell decision as an NPV
calculation. This briefing explores how a comparison of an IRR with an explicit DCF
valuation would identify the cause of the deviation between worth and value; particularly
whether this is due to differing cash flow expectations or target returns.
1.2 Accounting for potential costs and vacancies in the cash flow
Growth is not the only factor accounted for implicitly within an ARY, so are the risks of tenant
retention and default and the uncertainty around letting periods. The increments to the ARY
might be perceived as adding to the target return rather than adjusting the value for factors
not taken account of explicitly in the cash flow. This briefing explores how the process of
replicating a traditional valuation as an explicit calculation requires the uncertain nature of
the cash flow to be accounted for explicitly rather than buried within the capitalisation rate
revealing multiple potential investor returns around the target return.
1.3 Target returns
The briefing considers the theoretical components of a target return: the risk free rate and the
risk premium. This briefing breaks the risk premium into three aspects:
(1) Volatility,
(2) Liquidity and
(3) Transparency.
An explicit DCF would open the question as to the value of each component. Every investor
will have their own liquidity requirement and risk tolerance, but fundamentally a more
volatile, less liquid and less transparent property will have a higher target return. This
briefing explores the estimation of cash flow volatility, which reveals that volatility affects
both the target return and the cash flow.
1.4 The role of the valuer
The briefing then considers the role of the valuer. Traditionally, a valuer estimates the Market
Value of an investment property predominantly on the transaction price and the lease details
of comparable properties.
It is not possible for the valuer to impute any explicit cash flow assumptions, so an ARY is
derived that is then used to value other comparable properties. Other cash flow influences
such as growth, costs and vacancies are captured in the ARY and not the projected cash flow.
Journal of
Property
Investment &
Finance
381
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