Making discounted cash flow mainstream
The confidence builder for the valuation of real estate?
In what was a significant moment in the valuation profession, Peter Pereira-Gray in his report The Independent Review of Real Estate Investment Valuations, called for a much more analytical profession and one that uses discounted cash flow (DCF) as the principal approach to valuation.
The UK market has been predominantly using the growth implicit traditional approach as the ‘go-to’ method for years, so this is a significant change for the real estate industry, for the valuation profession, our clients and those who rely on our valuations, as well as our regulator – the RICS.
However, the call for a move to DCF was only one of the recommendations made in order to build confidence. All the recommendations were inter-related, with the objective of ensuring that our clients and those who rely on our valuations have confidence that the numbers reflect the market at the valuation date. As well as transitioning to DCF, both valuers and clients are getting ready for regular rotations and for a profession that is better governed and behaves differently.
The RICS now has the task of getting the valuation profession to modernise and to change.
What actually is a DCF?
Since the report was published, there has been a lot of debate about DCF, as most valuations of income producing assets are based on a future cash flow. Valuers are also thinking about how best to carry out DCFs and where to get the required data from. A DCF differs from the traditional approach in that it adopts the market’s assessment of future growth in an explicit way. That future income stream is then discounted back at a discount rate to derive market value. The traditional approach – which is currently the main method of valuation – differs in that it only uses today’s rental values and discounts the income at a rate based on analysis of comparable transactions.
What does this mean in practical terms?
Gone will be the expression that “it is all in the yield.” At the heart of the case for using a DCF, is that it will make valuers mirror how market participants price assets. Whilst it won’t necessarily apply to a shop let to a single tenant which would typically be sold in an auction, it is well suited to the valuation of most income producing investment grade real estate assets. In addition, it will give us a much more transparent and explicit way of showing income and cost trends.
Valuation language is changing – we are talking about internal rates of return and hurdle rates, rental growth and explicit costs. We are thinking about growth which is very relevant in the current inflationary economy. We are analysing our transactional evidence through DCF models to obtain market observed discount rates – using the valuers adage of “revaluing how we devalue.”
Consideration of financial markets has even more relevance when you are valuing by DCF than when you value on a traditional approach – particularly as it helps us to adjust comparable evidence when markets change quickly. Valuation will become much more data hungry as it gets more analytical, which I hope will also enable it to shed its reputation of being backwards looking in the assessment of value, and that it is slow to respond in times of rapid market movement.
As well as considering rental growth prospects, DCF also requires us to think explicitly about the impact of obsolescence and aging buildings. Furthermore, as the market looks at both the cost and benefit of moving real estate forward on its path to net zero carbon, DCF is really the only tool that can quantify economic impact.
With that comes the huge opportunity for gathering data for green initiatives as it emerges. Hopefully by sharing this data it will help our clients make better and faster decisions about their real estate.
Valuers and our clients are going to have to become more comfortable in the use of DCF. DCF is not complex from either an academic or mathematical perspective, but we are having to spend time with some clients’ debunking myths and helping them convert. However, the switch to DCF will not be an immediate fix – the valuation profession as a whole has to be confident that DCF produces an accurate market value. Without that, we cannot give confidence to those who rely on our advice. I suspect there will be a lot of dual reporting and a transition period – with both approaches used for a few years while the market converts to using DCF to determine market value. That way, as clients and valuers get more comfortable with the approach, and with better analysis of comparables, there will not be volatility in the value reported outwith movements in the market themselves”
There is also a risk that confusion will arise between market value and investment value, or worth. DCF is great at assessing both, but they are very different – and confidence will only come if clients and valuers understand that difference. There is a risk that some valuers will just use the growth-implicit traditional approach and then run a DCF and back-solve the discount rate to get to the same answer. That would be very much against the spirt of the review and one that would undermine rather than enhance confidence.
Valuers need to analyse transactions in a growth explicit model to see what discount rates are – but also to make sure that they are even closer to the runners and riders in any market to see how they price assets, what their hurdle rates are and how they model growth.
With all this new information, reported in an analytical way to our clients, I think that the valuation profession will change for the better. JLL is a strong advocate of DCF and use it across a number of different sectors – and has done for a number of years. There are clients who love DCF and those who don’t always see their relevance, but we think that the move to DCF is the right call by Peter Pereira Gray. Globally, DCF is already adopted as a primary valuation approach in many markets, and we are learning from our colleagues around the world as to how they use DCF and analyse their markets.
All our UK valuers have been trained to convert to a much more explicit way of valuing and specifically to understand how the market assesses discount rates and thinks about growth. We’re talking to our clients and our colleagues across JLL to get the right datasets in our tool kit – it has certainly never been a more interesting time to be a valuer.