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The debate about explicit Discounted Cash Flow (DCF) dates back at least as far as the Mallinson Report in 1994.
This debate has been rekindled by the RICS’ “Independent Review of Real Estate Investment Valuations” which recommends adopting an explicit DCF model as the primary approach for property investment valuations. This recommendation stems from the belief that explicit adjustments to cash flow projections, including growth, costs and vacancies, will enhance the valuation process and deliver better value to clients.
The response
The RICS issued a “Practice Information Note on Discounted Cash Flow Valuations” in November 2023. This report seems to have snuffed out any possible move to explicit DCF valuations from the valuers’ perspective. However, the Review’s recommendation focussed on clients, not valuers:
“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.”
If it’s the clients who benefit and the clients who pay the valuers, shouldn’t it be up to them to drive the switch? In this article, we outline the benefits of explicit DCF valuations for the recipients, hoping that early adopters will not only create a sea change in valuation practices but also transform the understanding, analysis and measurement of pricing and risks in commercial real estate.
Valuers must currently be making explicit adjustments for growth costs and vacancies.
Client perspective
Valuations serve multiple purposes, but for investment decision-making or comparing value with worth, an explicit DCF valuation offers significant advantages over an implicit one. The worth of any asset can be determined by the Net Present Value (NPV) of expected future cash flows, discounted at the investor’s target return. The decision to buy or sell relies on whether this calculation of worth exceeds the market value.
Rather than an NPV calculation, it is common practice in real estate to estimate the internal rate of return (IRR) of a property using a start value, a series of net cash flows and an exit valuation. The buy/sell decision is then based on whether the IRR surpasses the target, hurdle, or return. At face value, a client only requires a value as a starting point for their analysis. However, a deeper analysis reveals the need to also know the underpinning cash flow assumptions.
As an illustration, let’s restate a valuation as an IRR: if the initial cash flow is £100, growing by 2% per annum, and the target return is 5%, the value would be £102 divided by 3%, equating to £3,400. An investor paying this amount would achieve their 5% target return per annum. An implicit valuation utilises this 3% capitalisation rate, known as the All Risks Yield (ARY).
The return from the entry point of the IRR to any exit point with intermediate growing cash flows will reproduce the target return. Table 1 lays out this calculation:
Table 1: Five-year IRR calculation
| Growth | Start NPV | C/F Year 1 | C/F Year 2 | C/F Year 3 | C/F Year 4 | C/F Year 5 | IRR | |
| Growing | 2.0% | £3400 | £102 | £104 | £106 | £108 | £3864 | 5.00% |
Hence, the 3% ARY provides insufficient information to reproduce the valuation as an IRR as the growth assumption is required to compute the intermediate cash flows to identify the valuer’s target return. Only an explicit valuation provides sufficient information to this.
Importance of explicit assumptions
As the RICS Note explains, the ARY from an implicit valuation can imply multiple permutations of growth and risk premium assumptions, making it difficult for clients to reproduce the valuation as an IRR. The RICS Note covers more advanced adjustments to an ARY for reversion, rent receivable frequency and review clauses. From a client perspective this becomes important when calculating the exit yield, which becomes relatively simple with an explicit valuation but is not possible with an implicit one.
Comparable evidence
This raises an uncomfortable point for valuers: to adjust an ARY on a comparable transaction, explicit assumptions are required, unless the lease terms on the properties are identical. Without explicit assumptions, adjusting an ARY for differences in tenant covenant, unexpired lease term, or reversionary potential is not possible. Thus, valuers must currently be making explicit adjustments for growth, costs and vacancies, even if they do so implicitly!
Valuers may be reluctant to show their calculations, as comparable evidence will almost certainly be contradictory, but it is better to identify such contradictions explicitly than hide them in an ARY.
Stop fudging the exit value!
Clients must also tailor exit pricing to reflect the property’s lease characteristics at exit. Applying the same ARY at entry and exit is not a neutral pricing assumption. Even slight changes to the exit value can significantly impact the calculated IRR. Therefore, explicit valuations should be mirrored by clients in their worth analysis.
It is essential to recognise that differences in assumptions in a worth calculation can be justified based on factors such as varying cost of capital or management expertise, often referred to as alpha. Empirical measurement of alpha can validate these divergent assumptions and provide transparency regarding the expected investment performance.
Reducing confusion over target returns
Investors working from an implicit valuation can only compare the IRR with their target rate of return, which must be adjusted for risk. An ARY often introduces confusion, as differentials might mistakenly be interpreted as reflecting differences in risk.
In reality, they encompass differentials in growth, reversion and adjustments for costs and vacancies not explicitly incorporated in the cash flow. Consequently, two properties with the same target return and risk premium may exhibit different ARYs due to disparities in reversionary potential or lease terms. An explicit approach to valuation would reduce confusion surrounding target returns.
Compromise and transition
While explicit valuations offer clear benefits, it’s essential to acknowledge that valuation performs an essential role, providing stability during liquidity crises to ensuring the industry can function effectively – “close enough” using a traditional approach might be “good enough” in turbulent market conditions.
A potential compromise involves valuers providing explicit DCF valuations alongside traditional valuations. This dual approach encourages the creation of datasets for measuring explicit cash flow drivers, promotes more sophisticated modelling techniques, and fosters a learning culture in the industry. While this change might not alter individual valuations, it has the potential to significantly enhance the understanding of the drivers of risk and return in the real estate industry.
Enhanced confidence in valuations
Transitioning to an explicit approach could benefit valuers by reducing the likelihood of substantial disparities between perceived and actual values. As valuations form the basis of investment and lending decisions, and also the pricing of investment vehicles, higher confidence in valuation accuracy enhances the real estate market’s functionality. A valuation process reliant on comparable transactions is subject to particular uncertainty in periods of low transaction volumes. An explicit DCF approach could potentially allow transaction data from other, more liquid, financial markets to be used for market pricing.
It is our hope that the outcome of the Review will therefore be the adoption of explicit DCF valuations, informed by empirical market data, while maintaining the traditional ARY as the frontline valuation metric, supplemented by standard assumptions for incentives, costs, growth and vacancies.
