DCF: Property Worth Calculation

Chapter 7: DCF: Property Worth Calculation

7.1 Introduction

This chapter delves into the core principles and practical application of Discounted Cash Flow (DCF) analysis for determining the worth of a property investment. DCF analysis is a powerful valuation tool that explicitly accounts for the time value of money by discounting future cash flows to their present value. This allows investors to assess the profitability and investment worth of a property by comparing the present value of expected future benefits with the initial investment cost.

7.2 Fundamental Principles of DCF Analysis

At its core, DCF analysis is based on the fundamental principle that a dollar received today is worth more than a dollar received in the future. This is due to several factors:

• Opportunity Cost: Money available today can be invested to earn a return, making it grow over time.
• Inflation: The purchasing power of money decreases over time due to inflation.
• Risk: Future cash flows are uncertain, and investors require a premium to compensate for this uncertainty.

The DCF method quantifies these factors by discounting future cash flows using a discount rate that reflects the opportunity cost of capital and the risk associated with the investment.

7.3 Components of DCF Analysis

The DCF appraisal model comprises several key components:

• 7.3.1 Cash Flow Estimation:
  This is the most crucial and often the most challenging aspect of DCF analysis. It involves forecasting the expected cash inflows (e.g., rental income, parking fees, recoverable expenses) and cash outflows (e.g., operating expenses, capital expenditures, void costs, refurbishment) over the analysis period.

  • Rental Income: Projecting future rental income requires consideration of current market rents, lease terms, rental growth rates, vacancy rates, and potential lease renewals or break clauses.
  • Operating Expenses: Forecasting operating expenses involves estimating costs such as property taxes, insurance, maintenance, and management fees.
  • Capital Expenditures: These are significant investments in the property, such as renovations or major repairs, that can impact future cash flows.
  • terminal value❓:
    The terminal value represents the estimated value of the property at the end of the holding period. It captures the value of all future cash flows beyond the explicit forecast period. Calculating the terminal value is a crucial step. Several methods exist:

    1. Perpetuity Growth Model: Assumes a constant growth rate of cash flows beyond the holding period. The formula is:

       Terminal Value = CF(n+1) / (r - g)

       where:
       * CF(n+1) is the expected cash flow in the year following the holding period.
       * r is the discount rate.
       * g is the constant growth rate.
       2. Exit Multiple Method: Applies a multiple (e.g., exit yield, capitalization rate) to the expected income in the year following the holding period. The formula is:

       Terminal Value = NOI(n+1) / Exit Yield

       where:
       * NOI(n+1) is the net operating income in the year following the holding period.
       * Exit Yield is the expected yield at the time of sale.

• 7.3.2 Time Horizon:
  The time horizon, also known as the holding period, is the period over which the cash flows are projected. In DCF appraisal, a holding period of between five and 15 years is normally adopted. It is important to understand that the choice of holding period influences the weighting of cash flows and the contribution of the terminal value to the overall valuation.

  • Holding Period Length: Considerations include the investor’s investment strategy, market conditions, and the expected life of the property.

    Research has shown that a median holding period for commercial property as a sector is between eight and 12 years (Collett et al., 2003). Retail property was shown to have a longer holding period than small office and industrial property. Research by Buck (2003) at Kingston University in conjunction with IPD/DID also confirmed that the holding period for offices by UK institutional investors had a median of ten years, whilst in Germany this was significantly longer at 23 years. Buck also found that the age of property and the return were key factors influencing the holding period and that transaction costs had a minimal effect. The holding period reduces for properties acquired in a recession in order to increase fund performance.

• 7.3.3 Discount Rate:
  The discount rate, also known as the required rate of return, reflects the investor’s minimum acceptable rate of return for the investment, considering the risk associated with the property. The discount rate is a crucial input. It is also known as the required rate of return. The discount rate must incorporate both the time value of money and the risk inherent in the investment.

  • Capital Asset Pricing Model (CAPM): The CAPM is a widely used method for determining the discount rate:

    r = rf + β(rm - rf)

    where:

    • r is the required rate of return.
    • rf is the risk-free rate of return (e.g., government bond yield).
    • β is the beta coefficient, which measures the property’s systematic risk relative to the market.
    • rm is the expected market rate of return.

  • Weighted Average Cost of Capital (WACC):

    If the investment is financed with debt and equity, the WACC can be used as the discount rate:

    WACC = (E/V) * re + (D/V) * rd * (1 - Tc)

    where:

    • E is the market value of equity.
    • D is the market value of debt.
    • V = E + D is the total market value of the investment.
    • re is the cost of equity.
    • rd is the cost of debt.
    • Tc is the corporate tax rate.

7.4 Calculating Property Worth Using DCF

The property worth is calculated as the sum of the present values of all expected future cash flows, including the terminal value. The formula is:

PV = Σ [CFt / (1 + r)^t] + [TV / (1 + r)^n]

where:

• PV is the present value or property worth.
• CFt is the expected cash flow in period t.
• r is the discount rate.
• t is the period number.
• TV is the terminal value.

• n is the number of periods in the holding period.

• 7.4.1 Net Present Value (NPV): The NPV is the difference between the present value of cash inflows and the present value of cash outflows. A positive NPV indicates that the investment is expected to generate a return greater than the required rate of return, while a negative NPV suggests that the investment is not worthwhile.

  NPV = PV - Initial Investment

• 7.4.2 Internal Rate of Return (IRR): The IRR is the discount rate that makes the NPV of the investment equal to zero. It represents the actual rate of return generated by the investment. If the IRR is greater than the required rate of return, the investment is considered acceptable.

  0 = Σ [CFt / (1 + IRR)^t] + [TV / (1 + IRR)^n]

  The IRR is solved iteratively, often using spreadsheet software like Excel.

7.5 Practical Applications and Examples

To illustrate the application of DCF analysis, let’s consider a simplified example:

Example:

A commercial property is expected to generate the following net cash flows over a 5-year holding period:

• Year 1: \$100,000
• Year 2: \$110,000
• Year 3: \$120,000
• Year 4: \$130,000
• Year 5: \$140,000

The investor requires a 10% rate of return, and the estimated terminal value at the end of year 5 is \$1,500,000.

Using the DCF formula:

PV = ($100,000 / (1 + 0.10)^1) + ($110,000 / (1 + 0.10)^2) + ($120,000 / (1 + 0.10)^3) + ($130,000 / (1 + 0.10)^4) + ($140,000 / (1 + 0.10)^5) + ($1,500,000 / (1 + 0.10)^5)

PV ≈ $1,158,415

Therefore, the estimated worth of the property is approximately \$1,158,415. If the initial investment is less than this amount, the investment is considered worthwhile based on the DCF analysis.

7.6 Sensitivity Analysis

DCF analysis relies on numerous assumptions, making it crucial to perform sensitivity analysis. Sensitivity analysis involves examining how the property worth changes when key inputs, such as rental growth, discount rate, and exit yield, are varied. This helps identify the most critical variables and assess the robustness of the valuation.

• 7.6.1 Scenario Planning: Creating multiple scenarios (e.g., best-case, worst-case, most likely) to capture the range of possible outcomes.

7.7 Advantages and Limitations of DCF Analysis

DCF analysis offers several advantages:

• Explicitly accounts for the time value of money.
• Considers future cash flows.
• Allows for the incorporation of specific assumptions and forecasts.
• Provides a comprehensive framework for valuation.

However, it also has limitations:

• Relies heavily on the accuracy of cash flow forecasts.
• Can be sensitive to changes in the discount rate.
• Requires significant data and analysis.
• Can be complex and time-consuming.

7.8 DCF Analysis in Practice

Before embarking on the structure of a DCF model, it is important to recognise that the valuer is seeking to determine a single point estimate of value. In contrast, the property investment analyst using DCF methodology is seeking to identify worth in terms of the best estimate of the property’s worth, and is seeking to place this into a range of possible figures for the worth of the property.

When building a DCF model, the skill is to identify the known inputs and the variables, and to create a series of cash flow figures for each period over which the analysis is being undertaken from which the required outputs can be calculated. The framework of a DCF model is set out in an Excel worksheet.

The DCF appraisal model, thus, comprises a number of elements:
* Background information: relating to the property, the client, the author of the analysis, the analysis date and the name of the individual who has checked the spreadsheet.
* Known values: for example, the passing rent, the date of the next rent review(s), the floor area. In some instances the purchase price and the purchaser’s costs will be known.
* Variables: for example, the rental growth rate, the exit valuation yield, the required rate of return, the estimate of the open market rental value, non-recoverables, growth rate for non-recoverables.
* The analysis period: will the period over which the analysis is taken be one year, five years, ten years or even longer? Clearly the longer the period of analysis, the greater the degree of uncertainty that arises.
* The cash flow periods: under traditional valuation methods, there is an assumption that rents are received annually in arrears; in reality, they are normally paid quarterly in advance. The DCF will require to be set up with due regard to assumptions as to the cash flow periods.
* The net cash flows: the in flows minus the out flows. The net cash flow may also be known as the property’s net operating income.
* The debt cash flows: to produce the net cash flow for the equity investor, being the net property cash flows plus the money borrowed minus the debt service costs.
* The tax, grants and subsidies cash flows: to produce the net cash flows for the equity investor after tax and debt service costs.

7.9 Conclusion

DCF analysis is a powerful tool for determining the worth of a property investment. By carefully considering the various components, understanding the underlying principles, and performing sensitivity analysis, investors can make informed decisions about property acquisitions and dispositions. While DCF analysis has limitations, its ability to explicitly account for the time value of money and incorporate specific assumptions makes it a valuable asset in the arsenal of any property analyst.