The potential use of Discounted Cash Flow in real estate valuation
Simon Harrop, Associate Director, CBRE’s Valuation team in Leeds discusses the potential use of Discounted Cash Flow in real estate valuation following the recent RICS Valuation Standards and Regulation Board Review
Following the recent Standards and Regulation Board Valuation Review by The Royal Institution of Chartered Surveyors’ (RICS), it recommended the body contemplate the exploration of mandating consideration for Discounted Cash Flow (DCF) and its RICS Valuation Standards, specifically in a UK context.
A consultation on this issue has now concluded with the RICS Valuation Global Standards, UK national supplement becoming effective 1 May 2024. Initial proposals for this to include a mandate for all real estate valuers to consider (but not necessarily use) DCFs in their valuations of investment properties has not been taken forward at this time and does not, therefore, form part of the recently published UK national supplement 2023 update.
During the stakeholders consultation, it was determined that, while many support a standard encouraging greater use of DCF, that there were practical and technical issues surrounding the standards focusing on any one method of valuation in isolation.
What valuation method are valuers typically using?
The traditional income method, used in the majority within the UK real estate market, is somewhat unique to the sector within those markets where it is employed and, especially in an international context, doesn’t translate into portfolio performance measuring tools employed by many cross-border investors. Neither does it where commercial real estate is only one asset class within a larger portfolio with bonds, shares and other forms of investments valued on more cash flow based models.
What have been the criticisms of the Traditional Income Approach?
Critics of the UK traditional investment method cite the lack of forecasting of rental performance, suggesting the traditional method applies a simple capitalisation rate on current income only, with little regard for future shifts in occupancy and rental values. While it is true that most evidence of commercial real estate investment transactions is expressed in the form of a Net Initial Yield (i.e. the current net income divided by the gross purchase price), commercial real estate professionals are mindful in applying that evidence to the specific situation in valuing a commercial property.
The running yields to reach a stabilised occupancy at market rent are typically taken into account, together with the resultant equivalent yield and net value per square foot. Any current tenant vacancies and associated costs, imminent capital expenditure and likely costs associated with impending lease end dates or compliance with changing legislation are explicitly reflected.
However, it is true that the traditional investment method is growth-implicit in terms of rental growth that might be expected over the years. Instead, such rental growth is implied in the capitalisation rate applied. A property expected to have more rental growth potential would typically have a lower yield applied to it (resulting in a higher value) than one where less rental growth potential is expected. To some observers of valuation approaches, this rental growth does not appear to be sufficiently evidenced.
What is a Discounted Cash Flow and how does it differ from what has been used in commercial real estate valuation in the UK to date?
This is a significant topic and we can only go into broad details here. The key differentiator is that, while traditional income methods seek to reflect an asset’s investment performance in perpetuity (i.e. forever) once fully let and income producing at the opinion of rental value – using a growth-implicit capitalisation rate – the DCF seeks to model the likely investment life of an asset within an investor’s portfolio, with the emphasis on the ‘likely investor’ being that it is a market-facing hold period and investment scenario, rather than any one individual entity’s assumptions in this respect.
This means that explicit assumptions are applied concerning the income performance of an asset throughout the likely hold period of an asset. Not only is the DCF explicit regarding rental growth through the assumed hold period, but it also reflects operational and capital expenditure that may arise across the entirety of the hold period. Typically, as an example, traditional income methods do not explicitly model voids if they are likely to occur beyond a relatively short time frame (typically less than 5 years).
At the end of the assumed forecasting horizon an onward sale of the investment asset is modelled. The expected receipt on exit from the investment is arrived at using very similar methods to the traditional investment approach, by capitalising the – presumed stabilised – net income at the end of the hold period by adopting a suitable growth-implicit capitalisation rate – so in many ways a not insignificant proportion of the value is treated in a way very similar to traditional methods.
The resultant net annualised cash flow is then discounted back to reflect the time value of money, using a suitable discount rate, to arrive at a net present value of the investment asset. This can be considered the opinion of Market Value.
A typical metric applied to DCFs is the Internal Rate of Return (“IRR”), which is the discount rate across the cash flow that results in a net present value of zero. The relative expected performance of different assets can be compared by likening different IRRs directly to each other. Investors often use IRRs to gauge whether a proposal meets investment criteria concerning predetermined annual return targets – often related to an appetite for risk. A specific challenge in DCFs is analysing comparable sales evidence to gauge a particular market’s appetite for said risk, and this is one of the reasons critics cite for using traditional valuation methods as there is no direct evidence for the risk profile applied in any one transaction.
What are the complicating factors in adopting DCF methodologies?
The key, in all valuation methodologies, is that opinions on value vary. Any potential bidder for an investment opportunity, or the current owners of the same, will have a set of assumptions that they consider to be market facing, but they will also be rooted in specific market insight or particular business plans, which is when valuations run the risk of running into the territory of finding ‘worth’ to an investor rather than the value in the market as a whole.
It is the imperfect nature of the real estate investment market that means taking the pulse of the market is not as easy a task as, say, looking at share price movements. The opinion of value is based on publicly available information, but also dependent to a large extent on information that is only known by specific sets of market participants. Not all transactions are published, and even those that are will not provide a full picture of the assumptions made by the vendor and seller involved in a particular transaction.
In the traditional investment method, the Net Initial Yield is often given a great deal of importance. Typically, it is known what someone paid for an asset (at least when the transaction was subject to registration with HM Land Registry) and a marketing brochure will typically state the current income receivable on an annualised basis. Based on these two pieces of information, a Net Initial Yield can be calculated.
However, this only tells a partial story of the thinking that went into a particular transaction. If the property was vacant in part, how long did the purchaser assume it would take to let the vacant space and at what rent? What void costs were due? Was there any outstanding capital expenditure that was identified in a building survey or are there concerns about energy efficiency that need addressing? What Market Rent assumptions did the purchaser make concerning an outstanding rent review and when did they anticipate the property would be rack-rented? What is the market rent assumed by the purchaser? All of these considerations flow into a traditional investment method of valuation in applying an Equivalent Yield, but they are based on market intelligence rather than any independently recorded facts.
In adopting DCF methodologies, the potential list of data points grows significantly, and these data points are not usually evidenced in the market observations one can make. What assumptions did the purchaser make concerning a lease expiring eight years from the transaction date? Did they assume an extended vacancy period and one that might attract additional capital expenditure? What assumptions were made concerning hold period (and associated exit date) and what rental growth rates were assumed over that period? What sale price at the end of an investment hold period has been assumed, and how was that rationalised? Finally, what discount rate was applied by the purchaser in arriving at the transaction price? It is that last question that is the most open to interpretation.
Bearing in mind that the only piece of information that can be, as best as can be, independently verified in all methodologies, is the current income receivable and what someone chose to pay, adding additional complexities in DCF methodologies may be seen as clouding the issue in an already imperfect market.
As the various inputs in a DCF can have a measured effect on the net value, it is possible to arrive at a significant span of potential values when applying what, at first glance, appears to be a sensible set of inputs. Even when IRRs are the same between two valuations, the multitude of growth, void and capital expenditure assumptions across the hold period can result in different opinions of value.
Therefore, it will remain, in our opinion, important to benchmark key metrics such as Net Initial Yield and capital value per square foot in analysing the property investment market and to step back from valuations undertaken using any particular methodology to give the arrived at value a ‘sense check’. What the use of multiple valuation methodologies does mean, however, is that additional narrative or critique around the conclusions and assumptions will be required. If there is not alignment between the methodologies employed, then this represents an opportunity to critically review the rational and assumed risks.
This also means, however, that for less complex assets, the additional time invested in conducting a DCF may be unwarranted and not borne out by the pricing models used by market participants. An important note to consider here is that auditors employed by investors will also need to be able to validate the reasonableness of any valuation. Challenges around key assumptions is something we have seen increasingly with more incremental and detailed assumptions made in DCFs, and these may not be readily evidenced, which will be a challenge for the industry to navigate.
What will happen next and do investors need to do anything?
In the short term, it is expected that not much will change, and the RICS is not considering immediate changes to enforce specific valuation methods.
However, RICS guidance on how valuers need to account for their choice in valuation methodology employed will result in significant upskilling being required across the valuation profession. This is a process that CBRE has already undertaken.
The direction of travel does, however, appear clear – at least concerning those real estate assets that are considered to offer the most institutional grade investment opportunities. Some assets are already being appraised using DCF methodologies and it is likely that this will increasingly become the case.
Any transition to DCF methodologies is likely to take a long time, with different sectors of the market moving at different speeds. It is also likely that some elements of the market will remain unchanged from their present methodologies, with initial rent multiplied by yield approaches likely to prevail in many areas for some considerable time. It is probable that any transition will result in both traditional and DCF methodologies being used in analysing market evidence from recently completed investment sales for a number of years.
Above all, the principle that values follow the market must remain. We consider it likely that, even if a DCF methodology is employed as the principal valuation methodology, a holistic analysis of the resultant Net Initial Yield and capital value per square foot of lettable accommodation will need to be made. This is the most reliable comparator in the market at this time and the easiest to warrant through evidence. It will remain for the valuation professional to make a judgment as to what approach is the most warranted in any situation through the most likely method employed by likely market participants for a particular asset.
Increasing the number of valuation methodologies, when running in parallel, will increase analysis requirements on all advisors, investors and their auditors and the additional cost implications should not be underestimated.
What is the way forward?
The RICS has concluded that it will not, at this time, be mandating the consideration of DCF for the valuation of investment property in its 2023 update of the RICS Valuation – Global Standards: UK national supplement that will be effective from 1 May 2024.
Following the market, most of CBRE’s day-to-day valuation work continues to use the traditional income method, which is more readily evidenced in the UK market, but a number of clients are asking for analysis of the resultant valuations based on DCFs and an analysis of the arrived at IRRs.
CBRE has been extensively involved with the RICS consultation on the mandating of DCF methodologies. Also, together with other firms, a panel of our experts is meeting with industry-standard providers of external valuation software solutions used across the UK to ensure that a twin-track approach of methodologies can be employed while certain real estate asset classes go through what is likely to be a lengthy transition of years, or even decades, if they ever evolve away from the current methodologies.
For now, we are of the opinion that traditional valuation methods will continue to dominate in the majority of valuations of UK commercial real estate assets. DCF as a method of valuation is employed by us in those circumstances where we consider it to be the most likely method for ascribing value, or worth, by participants in the market, but those are the exception rather than the norm at this time.
