You are on page 1of 15

Discounted Cash Flow (DCF)

The DCF approach involves discounting all future receipts and expenditures similar
to the investment method of valuation, but they can be used allow for inflation,
taxation and frequent changes in income. Explicit assumptions are made rather than
implicit assumptions contained in the traditional All Risks Yield approach.
Support for the DCF approach came from the Mallinson Report published by the
RICS in 1997:
Report on the Presidents Working Party on Commercial Property Valuations
published by the RICS, March 1994.
Commercial Investment Property: Valuation Methods, an Information Paper
published by the RICS, May 1997.
Two principal methods of DCF calculations are
the Net Present Value method (NPV)
the Internal Rate of Return Method (IRR) - the rate when gives NPV = 0

Dr K Patel, Department of Land Economy, University of Cambridge

Net Present Value Method


In the NPV method the present value of all future receipts from an asset is compared
with present value of all outgoings. If the present value of receipts exceed the
present value of outgoings, the investment is worthwhile.
The Discount rate: the future receipts and outgoings are discounted at an appropriate
discount rate. When calculating the worth of an investment to an investor the
discount rate will be the investors target rate. When the method is used to determine
a general market value a discount rate must be adopted which is best approximates
the majority of individual target rate.
The discount rate is commonly arrived at by adopting a risk-free rate and making
allowances for the risks associated with the property in question.
The risk-free rate is generally taken as the gross redemption yield on medium-term
government gilts (bonds). This has ranged between 7% - 10% over recent years. To
this is added a risk premium, say 2%, to reflect the general risks of investing in
property such as illiquidity, location, strength of covenants, depreciation, risks of
voids, etc.

Dr K Patel, Department of Land Economy, University of Cambridge

The DCF calculation makes specific assumptions as to the rate at which the various
elements of the calculation will change in the future. The rates of growth may be
different. E.g., it may be assumed that rents will grow faster than building costs.The
valuer will often rely on his judgement as to growth rates.
Where the valuer knows the All Risks Yield (ARY) appropriate to a property and
also the discount rate, an implied rate of growth of the rental value can be
determined.
The All Risks Yield equals the discount rate minus the annual sinking fund to
recoup the growth in rental value over the review period at the discount rate.
Assume that ARY = 6%, the discount rate is 10%, and there are 5-yearly rent
reviews, then
10 = 6 + (SF 5yrs @ 10%) x growth over 5 yrs.)

0.10
6% +
x growth over 5 yrs.
(1.1) 5 - 1

Growth over 5 yrs = (10 - 6)/0.1638 = 24.62% i.e. 4.5% annual growth rate

Dr K Patel, Department of Land Economy, University of Cambridge

Freeholds with Annual Rent Review


The basic DFC method can be stated as
R0
R 0 (1 + g ) R 0 (1 + g ) 2 R 0 (1 + g ) 3
+
+
+
+ ...
P0 =
2
3
4
1+ r
(1 + r )
(1 + r )
(1 + r )
which simplifies to
P0 =

R0
r-g

where R0 is the current rental and g is the expected rental growth


The current rental yield, k, also referred to as the capitalization rate, is
k=

R0
P0

and from above we have k = r - g


Dr K Patel, Department of Land Economy, University of Cambridge

Calculation of Implied Rental Growth (Baum & Crosby)


Example 1: A freehold property has just been let on a 25-year lease with 5-year rent
review as a net rent of 200,000 pa and subsequently sold for 4,000,000
200,000
Capitalization rate k = 4,000,000 = 0.05 or 5%

Suppose that the equated yield, e, (also referred to as the assumed target rate) is 13%
Implied annual constant rental growth rate is g.
Capital gain:

P t - P0
= P 0 (1 + g) t
P0
Pt
= P 0 (1 + g) t - 1
P0

If the original capital sum is 1 the the capital gain is (1+g)t - 1

Dr K Patel, Department of Land Economy, University of Cambridge

The implied constant rental growth rate can be worked out as follows.
The equated yield, e, is made up of the capitalization rate, k, plus the annual sinking
fund to replace the capital gain at the equated yield over the rent review period:

e = k +
Rearranging,

k = e -

e
(1 + e) t - 1
e
(1 + e) t - 1

x [(1 + g ) t - 1]

x [(1 + g) t - 1]

1
1
1 - (1 + e) t
t
=
+ (1 + g) x
k
e
k(1 + e) t

(1 + g )

YP perp. @ k - YP t yrs. @ e
=
YP @ perp. @ k x PV t yrs. @ e

Dr K Patel, Department of Land Economy, University of Cambridge

As in the previous example suppose that t = 5 years, k = 5%, e = 13% then g can be
calculated as follows

(1 + g ) t =

YP perp. @ 5% YP t yrs. @ 13%


YP @ perp. @ 5% x PV t yrs. @ 13%

20 3.5172
16.4828
=
= 1.5185
20 x 0.5427
10.855

g = (1.5185) 1/5 1 = 0.0871

or 8.71% pa

Dr K Patel, Department of Land Economy, University of Cambridge

Example 2: Value the freehold interest in a shop to be let on a 25-year lease with 5-year
reviews at its current net rental value of 100,000 pa. Assuming a holding period of
30 rears, equated yield 13%, implied growth rate 8.712%, and market capitalization
5%.
Capital value = ERV/k = 100,000/0.05 = 2,000,000
Rental
807,160
531,580
350,090
230,560
151,840
100,000

10

15
Years

20

Dr K Patel, Department of Land Economy, University of Cambridge

25

Perp
8

Valuation assuming a holding period of 30 years:


Years
0-5
6-10
11-15
16-20
21-25
26-30
30

Current g @ 8.712%
ERV pa
100,000
1.0000
100,000
1.5184
100,000
2.3056
100,000
3.5009
100,000
5.3156
100,000
8.0716
100,000
12.2562

Forecasted
Income
100,000
151,840
230,560
350,090
531,580
807,160
1,225,620

YP 5 yrs
@ 13%
3.5172
3.1572
3.1572
3.1572
3.1572
3.1572
20.000*

PV @ 13%
1.000
0.5428
0.2946
0.1599
0.0868
0.0471
0.0256

Present Value

351,720
289,870
238,890
196,880
162,260
133,720
626,660
2,000,000

* YP in perpetuity @ 5% to establish the exit value

Dr K Patel, Department of Land Economy, University of Cambridge

Example 3: Value the freehold interest in a shop which was recently let for 20 years at
20,000pa with 5-yearly reviews. All risks yield is 6%.
Conventional Method
Rent reserved and full rental value
2,000
YP in perp. @ 6%
16.667
Capital value
333,334
DCF Method discount rate is 10%, growth rate 4.5% pa
Years
Cash flow
YP@10%
PV@10%
1-5
20,000
3.7908
6-10
24,884
3.7908
0.6209
11-15
30,961
3.7908
0.3855
16-20
38,522
3.7908
0.2394
20 to perp.
47,929
16.6667*
0.1486
Net Present Value

Capital value
75,816
58,570
45,249
34,959
118,704
333,294

*YP in perpetuity @ 6% to establish exit value.


Dr K Patel, Department of Land Economy, University of Cambridge

10

Example 4: In Example 3 assume that on expiry of the lease the freehold owner will
need to spend 80,000 at current prices and building costs are expected to rise at 3%
pa. It is expected to take 3-month rent free period to relet and a 3-month rent freeperiod is likely. The rental value will be unchanged by the work.
Years
Cash flow
1-20
as before
21
(146,400)
22
49,547
Net Present Value

YP@10%

PV@10%
0.1452
0.1385

Dr K Patel, Department of Land Economy, University of Cambridge

Capital value
214,594
(21,257)
114,373
307,710

11

Example 5: In Example 3 assume that the property was let 12 years ago, the current passing rent
fixed two years ago is 17,000 pa., and the lease is 8 years unexpired.
Conventional Method
Term
Rent reserved
17,000
YP 3 yrs @ 6%
2.6730
45,441
Reversion
Full Rental value
20,000
YP perp. Def. 3 yrs @ 6%
13.9937
279,874
Capital value
325,315
DCF Method
Years
1-3
4-8
8 to perpetuity
Net Present Value

Cash flow
17,000
22,824
28,397

YP@10%
2.4869
3.7908
16.6667

PV@10%
0.7513
0.4665

Dr K Patel, Department of Land Economy, University of Cambridge

Capital value
42,277
65,003
220,787
328,067
12

Internal Rate of Return: Equated Yield Rate


The NPV method assesses an investment by discounting the future receipts and
outgoings at a selected discount rate. The selected discount rate may produce the
result that NPV < 0, NPV = 0 or NPV > 0.
The IRR method determines the value of the discount rate by trial and error such
that NPV = 0.
The expression equated yield has been given different definitions. The equated yield
is in fact the IRR: the discount rate which needs to be applied to the projected
income (allowing for growth) so that the summation of all the incomes discounted at
this equated yield rate, equates with the capital outlay. It may be estimated by using
the following formula:

NPV1
R1 + (R 2 - R1)
NPV1 + NPV2
where NPV1 is caluculated using the lower discount rate R1 and NPV2 is calculated
using the higher discount rate R2.
Dr K Patel, Department of Land Economy, University of Cambridge

13

In Example 3 assuming the offered sale capital value of the shop is 300,000, the
IRR can be caluculated as follows:
Assuming that estimated growth is 4.5% and discount rate of 10% the capital value
is found to be 333,294. The difference between 333,294 and the offered sale
price 300,000 is 33,294.
Try 12%.
Years
Cash flow
1-5
20,000
6-10
24,884
11-15
30,961
16-20
38,522
20 to perp.
47,929
Net Present Value

YP@12%
3.6048
3.6048
3.6048
3.6048
16.6667*

PV@12%
0.5674
0.3220
0.1827
0.1037

Capital value
72,096
50,897
39,308
25,370
82,837
270,508

At 12% the NPV is 270,508. It is 29,492 below the offered sale price of 300,000.

Dr K Patel, Department of Land Economy, University of Cambridge

14

The IRR can be now estimated using the two values of R1 = 10% and R2 = 12% and
NPV1 = 33,294 and NPV2 = 29,492

NPV1
R1 + (R 2 - R1)

NPV
NPV
+
1
2

33,294
10% + (12% - 10%)
33,294 + 29,492
= 11.06%
In fact at 11% the NPV is 2,388 below the offered price 300,000.

Dr K Patel, Department of Land Economy, University of Cambridge

15

You might also like