DISCOUNTED CASH FLOW – NOTES (August 2007)
Introduction
I have been asked to prepare some notes prior to my presentation scheduled for the 24thAugust 2007.
There are a certain number of misconceptions regarding discounted cash flow methodology that need to be resolved.
The first, and most common, of these is that DCF methodology is a separate method to the income approach whereby the net annual income of a property is capitalised by an appropriate capitalisation rate to arrive at the estimated market value of the property.
On the contrary, a discounted cash flowis merely an extension of the income capitalisation approach and is employed to take cognisance of contractual rental income that may be either above (top-slice) or below (under-slice) market-related rentals.
The principle stems from the concept “huur gaat voor koop”which I’m sure most of you have covered in your studies. In essence, the concept may be summarised as follows: if a property that is subject to lease is sold, the rights of the lessee continue until expiry of said lease.
This could have a major implication to the hypothetical purchaser. For instance, if the property is subject to a ten year lease that still has five years to run and that may, due to, say, escalation build-up, be significantly higher than market, is it reasonable to assume that the purchaser would pay the same for this property as he would if the property was not subject to lease?
The lease provides a certain security of value that would surely attract a certain premium over a similar property that was not subject to a similar lease. Conversely, the property may be subject to a lease significantly below market. In this instance, would it not be reasonable to conclude that the hypothetical purchaser would discount his purchase price to a certain degree?
The second common misconception is that this method involves the use of complex mathematical formulae that are beyond the reach of the ordinary practitioner. The truth is that discounted cash flow analyses can be carried out using excel or even a calculator and, in essence, knowledge of only two formulae are generally required.
The first of these is the capitalisation formula: which I am sure most, if not all of you, are familiar with and, the second, the discounting formula: which, again, I’m sure most of you are familiar with.
In essence, a discounted cash flow generally takes the following form: rental received is escalated by the contractual escalation rate until expiry of the each lease, whereupon market-related rentals are introduced and in turn escalated at a smoothed market growth rate, until such time as all rental income (for a full year) is market-related. Similarly, expenses are escalated at an appropriate rate, for the same time period.
The net income for each year is discounted to the date of valuation with the net rental in the final year of calculation (market rental) capitalised into perpetuity at an appropriate capitalisation rate and discounted to the date of valuation. The sum total of the net present values represents the value of the property.
My presentation will cover issues such as:
- Uses of discounted cash flow methodology;
- Arriving at an appropriate discount rate – differing schools of thought;
- The difference between lease escalation and market growth;
- Unnecessary use of DCF methodology.
For those of you who wish to do so, I attach a simple exercise that adequately demonstrates the concepts and use of discounted cash flow methodology:
Exercise
An industrial property is fully let to a single tenant on the following terms:
Tenant / Period / Area / Expiry Date / Commencing Rental / Annual EscalationOswald’s Cash and Carry / 5 yrs / 1,800m² / 31/12/2007 / R 12/m² / 8%
Tenant responsible for building maintenance and municipal service charges. Landlord responsible for full property rates, insurance premiums and sundry expenses which, at the date of valuation, are as follows:
- Annual Municipal Rates
3.8 cents in the rand on a municipal land value of R 750,000
0.5 cents in the rand on a municipal building value of R 1,600,000
- Annual Insurance Premiums
R 2,20 per R 1,000 of replacement cost, estimated at R 2,800,000
- Sundry and Audit Fees
For the year R 5,000
- The above expenses escalate at 15% per annum.
- The market rental value of the premises after expiry of the lease is estimated to be R 20/m². Market rental escalations are currently 10%.
- Similar property investments are currently yielding 12,5% on market rentals.
- For the purposes of this exercise, assume discount rate of market growth plus capitalisation rate.
What is the market value of the property as at 1/11/2004 and what is the initial yield?
I attach the solution on the next page but suggest that you attempt the exercise without referring to it unless you absolutely have to. It is important that you understand the concepts of discounted cash flow methodology and this exercise attempts to demonstrate these.
Answer
Any of you are welcome to contact me at any time to discuss any aspect dealing with the above or any other valuation matter or to send me an email.
Enjoy the course and make the best of it. I look forward to meeting all of you.
Best Regards,
Ken
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