Week 4, Session 7

Investment Valuation – Discounted Cash Flow

(DCF)

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 Summary QFQ’s

1. Why and how would you use DCF analysis to value

investment property?
2. Using the DCF approach requires some forecasting of the
future – how can this be done?
3. How does a lease impact on DCF analysis?
4. What does the IRR in a DCF valuation means and how is
it found?
5. What are the critique of DCF?

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Recap – Direct Capitalisation

 The three valuation scenarios

Market (Rack) Rented

Market Rent
$200

Under Rented (Rental Shortfall) Over Rented (Overage)

Market Rent $220 Contract/Passing Rent

$200 Surplus
Shortfall
Shortf
$200
$180 all Contract/Passing Rent Market Rent

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 Observations…

 Reversion always capped at today’s Market Rental (MR)

 Rental growth implicit in Market Yield usually termed All Risks
Yield (ARY)

Rental growth
$
MR ceiling
20 perp
0

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 DCF - Definition

 …a technique whereby estimated future monetary cash

flows over a specified investment period are discounted to
present value.

 Essentially discounts future benefits - income streams

(cash flows) and the future reversionary (terminal) or
residual value (estimated future sale price) - to present
value (estimated market value).
 Future benefits are namely:
 Income
 Resale (capital appreciation)

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DCF – Visually

$
cash
flow
PV $1

1 2 3 4 5 t

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 DCF - Formula

Present Value =
∑( (Cash flow)
period
(1+discount rate) ) + Terminal Value

PV = ( (1+r)
(CF )
t
t
+
(CFt+1)
(1+r) t+1
+
(CFt+2) . . . . .
(1+r)t+2 ) +
(TVt+1)
(r)

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 DCF - Why?

 Investors are increasingly concerned about accountability and whether

a particular investment will provide an adequate or required return
over the holding period (investment time-frame).

 DCF is a more sophisticated approach, involving explicit estimations of

future monetary benefits extending within a specific investment time-
frame.

 They can be used by real estate people to represent a projection of the

expected income and expenses of either a single property or portfolio.

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 DCF - Requirements

 Cash flow
 Usually in the form of rental payments from one or multiple tenants.
 Cash flow frequency
 Normal convention to allow future cash flows in equal periodic payments. For
example, yearly, semi-annual, quarterly or monthly.
 Investment period
 DCF’s require cash flows to be forecast over a future investment (holding) period
(usually 10 years).
 Beginning or end of period conversion
 Indicates the timing of the cash flows.
 The end of period payments (EOP) or more commonly the beginning of period
payment (BOP).
 Growth assumptions and forecasts
 Essential to use reliable research. For example, NZIER, other private sources.

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 DCF - Requirements

 Purchase/start value
 The price/value paid or estimated for the property represented as a negative cash
flow at Year 0.
 Only used when requested to establish the “Internal Rate of Return”.
 Exit/Terminal value
 The projected end value of the property at the termination date.
 This is normally to be included at the end of the final year of the cash flow.
 Discount rate and risk premium
 Contentious issues but should reflect risk including lease covenants, market
conditions and age/quality of building.
 Expenditure
 Usually non-recoverable operating costs, refurbishment, building expansion and cost
of funds.
 Terminal/Exit yield
 The capitalisation rate applied to the estimated cash flow at the termination date
used to calculate the exit value

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 Discount Rate (DR)

 Represents the opportunity cost of capital for the typical

investor in the asset class.
 Usually most sensitive input.
 How determined?
– Extract from market sales i.e. “solving” DCF for IRR.
– Yield construction i.e. risk free rate + market risk + property risk.
– Opinion based on experience i.e. professional & client input.
– Financial techniques i.e. WACC & CAPM.
– Published data i.e. empirical research & investor surveys.

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Internal Rate of Return (IRR)

 “ the annual nominal interest rate of return (otherwise

known as the discount rate) that is required to give a net
present value of zero.”

 A complex method of determining whether you should

invest in property.

 The IRR is established through a process of interpolation,

which makes the present value of cash outflows (purchase
price plus costs) equal to the present value of all the cash
flows (rental income plus sale).
 More simply, the rate to make all cash flows (NPV) equal zero.

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 Lease - Definition

 A contract entered into between a landlord and a tenant to

occupy a building, or part of a building for a predetermined
period for a market rental and a set of other conditions.

 Most common commercial lease used today is the

Auckland District Law Society Deed of Lease, 5th Edition
(2008) & 6th Edition (2012)
• The ADLS’s Sixth Edition makes it possible to employ a
combination of both a market and CPI rent review
• Clause 2.5 set out the formula for rent adjustment based on CPI

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Lease – Key provisions

 Total Occupancy Rental/ Cost (TOC):

 A rental paid by the tenant which includes the accommodation rental and all
operating costs including water etc with the exception of some utilities (i.e.
electricity in some cases) and internal cleaning. Again dependent on specific
lease clauses/ structure and building structure.
 Net Rental:
 The accommodation rental a tenant pays to a landlord. It excludes all
operating expenses which are normally on charged to the tenant in addition to
the accommodation rental.
 Semi-Gross Rental:
 Rental paid by the tenant which includes the accommodation rental and most
of the operating costs, but can exclude rates, insurance etc (depending on
lease structure) and excludes utilities and internal cleaning.

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Lease – Key provisions

 Ratchet clause
 A clause often placed into a lease that prohibits the contract rental on a
property from falling. There are two types:
 Hard ratchet – rental not falling below the preceding 12-month period.
 Soft ratchet – rental not falling below rental at the commencement of the lease
term (Standard in ADLS 5th Ed.).
 Rent review
 Periodic review of the contract rental. Usually two or three yearly.
 The rental is either adjusted to market or by a structured increase such as CPI
or CPI plus one.
 Right of renewal
 An additional lease term granted to the tenant who has the sole right to invoke
if they wish, at the end of their original lease term.

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Lease – Key provisions

 Annual rent
 The annualised rental paid by a tenant to the landlord, usually monthly in
advance. The rental can be either on a net, gross or total occupancy basis.
 Common areas
 Areas of a building shared by a group of tenants, such as lobbies and staff
amenities.
 Lettable area
 An official measured area determined by industry guidelines.
 Office and retail property are measured on a net basis (NFA).
 Industrial and residential are measured on a gross basis (GFA).
 Operating expenses
 Cost required to keep the property functioning, such as rates, building
services, external cleaning, management etc.

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DCF – Valuation Example 1

Find the Indicated Market value (NPV) and IRR based on the following assumptions

Assumptions/Inputs
Valuation date Today
Holding period/Cash flow timeline 5.00 years
Timing of cash flow EOP
Gross (TOC) contract rental $100,000.00 p.a. plus GST
p.a. plus GST and
Net market rental $90,000.00 OPEX
Non-recoverable lease OPEX -$8,000.00 p.a. plus GST
Other non-recoverable OPEX (e.g. landlords
maintenance) -$800.00 p.a. plus GST
Capital expenditure (CAPRX) - Year 3 -$10,000.00 plus GST
Lease term 6.00 years
Rental reviews (RR) 2.00 yearly
Ratchet clause Soft
Est. rental growth 3.00% p.a.
Est. OPEX growth 0.00%
Terminal property yield 9.00%
Market derived cap rate 8.50%
Discount rate 8.25%
Purchase price $1,045,000 Plus GST
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DCF – Valuation Example 2

You have been asked to value a commercial property, as at today, by way of the Discounted
Cash Flow Approach. The property is subject to a new ten year lease commencing today at
a gross commencement income of $280,000 per annum plus GST, paid yearly in advance.
You have been provided with the following assumptions / determinants:
• DCF period: 5 years
•Discount rate 8.25%
•Terminal yield 8.75%
•Current net market rental $195,000 per annum plus GST and OPEX
•OPEX $60,000 per annum plus GST
•Rental reviews: 2 yearly to market
•Ratchet clause: Hard
•Market rent increase 2.5% p.a. compounding
•OPEX increase 3.0% p.a. compounding
•Purchase price $2,400,000 plus GST
•CAPEX $40,000 plus GST at the end of year 3
Find the indicated market value and the internal rate of return (IRR) using the DCF

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 DCF – Advantages

 Forces user to consider all factors – explicit method.

 Used to value property with fluctuating income and
varying lease terms – multiple tenants.
 Considers the time value of money (TVM) and investors
required rate of return.
 Reflects variation between contract and market rents in
TVM.

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 DCF – Pitfalls

 Requires the estimation of many different parameters

that are often no more than “guestimates”.
 Unrealistic growth assumptions and timing of cash flows.
 Too long or short investment period.
 Unjustified reversionary (or residual) values.
 Failure to apply sensitivity analysis.

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 Next …

Investment Property

>>FACULTY OF TECHNOLOGY AND BUILT ENVIRONMENT >>DEPARTMENT of CONSTRUCTION

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