Introduction
Traditionally, property investments have been valued by applying an all-risks yield (ARY) to the estimated market rent of the property. If ARY is defined as observed market rent/observed gross market price, then the estimated market value of the property would be Market rent/ARY.
Market rent is the estimated amount for which a property, or space within a property, should lease on the date of valuation between a willing lessor and willing lessee on appropriate lease terms in an arm's-length transaction after proper marketing wherein the parties had acted knowledgeably, prudently and without compulsion.
The use of the ARY method embeds assumptions about future cash flows that are not explicitly modelled, for example, future rental value changes. In periods of rapid structural change concerning everything from the broader economy to legislation, the ARY model does not allow the valuer to be flexible; thus, it compromises accuracy. Additionally, valuation techniques like the ARY method are typically used to estimate the price at which a property could be bought or sold in a market environment.
Another potential value that might be of interest is often referred to as investment value, which is an estimate of the value of a property to a particular investor. Investment value will usually differ from market value due to different income requirements, risk assessments, growth expectations and capital expenditures, and tax positions. One method of real estate valuation that explicitly considers several of these variables is discounted cash flow (DCF). This article will discuss the DCF framework applied to real estate valuation, critical assumptions used in estimating property investment value, and how variations in the assumptions affect the resulting estimate of value.
The DCF framework
A DCF model estimates the value of a property by discounting back all future expected cash flows arising from that property. It requires:
Forecasted stream of cash flows over a given horizon
An expected terminal value
Discount rate that reflects the market and specific project risks.
Forecasted cash flows
These should reflect both income and expenditures. Typically, cash flows are forecasted for five, ten or 15 years, and this should be based on lease expiry dates, lease renewal periods and break clauses. The timing of cash flows impacts valuation. Therefore, the more accurate the cash flow frequency is, the more accurate the resulting valuation will be.
Cash outflows that should be included are:
Initial investment, including fees if financing is part of the structure
Expenses of operating and owning the property, including income and capital gains taxes
Capital expenditures for the refurbishment of the property
Selling costs
Cash inflows that should be included are:
Rents collected from the property
Expected proceeds from the disposal of the property
Terminal value
The terminal value represents the price that the investor expects to receive for the property at the end of the holding period. This expected value should take into account the anticipated physical condition of the property, rental growth, leasing terms and remaining tenure on the exit date, and movements in interest rates and property yields.
Typically, exit values are calculated by applying an ARY to the expected market rent at the end of the holding period. All else equal, the higher the terminal cap rate used, the lower the exit value and vice versa.
Historical evidence indicates that terminal cap rates have varied dramatically from 3 per cent to 12 per cent. A typical rule of thumb would be 7 per cent to 10 per cent, with a higher cap rate used for properties with a riskier profile.
Discount rate
The discount rate brings all future forecasted cash flows and the terminal value back to a value at the same point in time (valuation date). Since the cash flows generated by an investment property carry a risk level, the discount rate should compensate the investor for the risk taken by investing.
A standard method of determining the discount rate is the capital asset pricing model. The problem is that CAPM is based on a few underlying assumptions that may not apply to real estate valuation, such as:
An efficient market environment
The fact that market risk is rewarded in the form of higher returns, but the specific risk is not because it can be diversified away
Property markets are inefficient because no two properties are the same, and real estate is not traded on an organized market with regularity. Empirical evidence indicates a considerable variation in the relationship between risk and returns in a way that the CAPM would not predict.
So, for real estate, it may be concluded that specific risks matter and should be considered in the discount rate. Therefore, the discount rate can be calculated as follows:
The following factors are essential in determining the level of each premium:
Some of these risks can be incorporated into the cash-flow forecasts for a specific property or through a scenario analysis where a range of discount rates is used to determine multiple valuation outcomes.
Alternative approaches for determining the discount rate applied to cash flows in a model designed to calculate investment value includes:
These rates, typically used in private real estate investing, could be 20 per cent, 30 per cent or even 35 per cent.
A DCF model example
The following example intends to illustrate how to build a DCF model to estimate the investment value of a commercial building as of December 1st, 2011.
Firstly, certain assumptions are needed to set up the DCF model. They will be used to estimate the property cash flows over the investment holding period (5 years in this example). In this example, we assume that rents are paid quarterly at the beginning of the period.
Building the cash flow forecast
To build the cash flow forecast, we start by spreading the quarterly rental payments out over the investment holding period using the current annual rents, expiry dates and rent review dates. For example, the first floor generated a rental income of $30,000 per quarter in December 2012 (corresponds to an annual rent of $120,000 divided by four quarters). After the rent review date for the first floor in December 2012, we adjusted the rental income to an inflation level of 1%, which corresponds to a $37,870 rental income.
The first-floor lease contract expired one year after the end of our investment holding period in December 2017, so we only take vacancy and refurbishment costs into account when calculating the exit value.
The second-floor lease contract expires at the beginning of September 2012, which means cash flow forecasts during the investment holding period will be based on current rental rates before the expiry date; refurbishment costs, carrying costs and taxes, and a leasing fee during the expected vacancy period; and the expected rental value forecast after the rent-free period. Note that all costs post-lease expiry and the subsequently expected market rents should be adjusted for price inflation.
The cash flow streams over the investment holding period for the third to ninth floors can be calculated the same way as those of the second floor, with current rental rates shown quarterly before lease expiry, price-inflation adjusted refurbishment and other costs included during the vacancy period, and price-inflation adjusted estimated rental values beginning after the rent-free period.
Estimating the exit value
1. The value of the remaining rental payments as per the contracts in place at the end of the holding period. We will call these payments "passing rent".
2. The value of any refurbishments, vacancy carrying costs, real estate taxes and leasing fees needed to bring the state of the property back to long-run equilibrium.
3. The value of all future expected market rents after the final refurbishment and carrying period. This value is typically calculated by dividing the final rent-inflation-adjusted ERV by a capitalization rate that considers the risk profile of the investment at exit date and anticipated market conditions. In this example, assume a capitalization rate of 7.5 per cent.
Since the investment holding period ends December 1st of 2016, one year (four quarters) is left on the first-floor lease at the forecasted passing rent level ($39,870 per quarter). The lease on the first floor expires in December 2017.
At the expiry date, refurbishment costs, vacancy carrying costs, real estate taxes and a leasing fee need to be calculated to bring the state of the property back up to long-run market equilibrium. The remaining value at the end of the vacancy period can then be calculated by dividing the ERV by the cap rate ($179,083 divided by 7.5 per cent, in this example).
The exit value for the first floor can thus be calculated as follows:
The value of the remaining rental payments (discounted back to December 1st, 2016, at a cap rate of 7.5 per cent) of $147,500.
The value of all costs incurred to bring the state of the property back to long-run equilibrium (also discounted back to December 1st, 2016 at 7.5 per cent) of $1,874,300.
The lease on the second floor expired in September 2012. As such, we included costs for refurbishment and vacancy in our explicit cash-flow forecasts during the investment holding period. Therefore, the exit value for the second floor can be calculated as follows:
The value of the remaining rental payments (discounted back to December 1st, 2016, at a cap rate of 7.5 per cent) of $1,233,200.
The value of the reversionary ERV (discounted back to December 1, 2016 at 7.5 percent) of $3,624,000.
Summing these values, we reach an exit value attributed to the second floor of $4,857,200.
Following the steps above for the third to ninth floors and the tenth-floor results in exit values for those spaces of $33,908,200 and $3,893,100, respectively.
The final step in calculating the total exit value as of the exit date is to deduct the purchaser's costs and a charge for sales costs.
Once we have calculated the total forecasted cash flows over the investment holding period, we can estimate the investment value of the property by discounting these cash flows back to the investment date using a discount rate that reflects the time value of money and the risk of the investment and summing these cash flows.
Sensitivity to assumptions
The valuation process and the resulting bottom-line value are susceptible to the assumptions used in the model. We should use realistic, well-reasoned assumptions in the process of investment decisions.
How do we do this? By using a range of assumptions for certain key variables. This way, we can see how sensitive the underlying value estimate is to the modeler’s choices.
We can see that bottom line valuation is affected by many factors that the investor doesn't control:
Changes in the size of the property - since square footage to one increased/decreased, so does the respective cash-flows
Vacancy rates - higher vacancy rates lead to increase costs and reduce rental income at the same time, which lowers the resulting valuation
Changes in rental and cost growth rates - higher growth rates have a more significant effect on expected future cash flows
Changes in the interest rates - lower interest rates imply a lower discount rate, which increases the property valuation
Changes in the lease terms - longer lease durations improve the visibility of rental income streams, and therefore reduces some of the property risks
Conclusion
In conclusion, we have discussed the DCF framework applied to real estate valuation, critical assumptions used in estimating property investment value and how variations in the assumptions affect the resulting estimate of value. This framework allows us to have some perspective of the market valuation; however, to be successful in your investment, you must take this kind of valuation directed explicitly to it, not just the general way.
AUTHORS:
Francisco Marques
Luísa Lourenço
Teresa Rodrigues
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