Of the many ways we value commercial real estate, it’s hard to argue against the tenets of a discounted cash flow valuation.
But there are potential weaknesses, so in this commercial real estate resource blog, we break down the exact benefits and shortcomings of the DCF, in short, everything you need to know when presenting, receiving, or underwriting your own discounted cash flow model.
The bottom line is that everyone thinks differently. When we were in business school, we learned about diversity. But now that we’re all grown up, we know there are plenty of similarities in our thinking, most notably, the bottom line. In the niche of commercial property valuation, understanding the standard valuation method is critical to understanding the bottom line, and when we’re dealing with seven, eight, or nine digit property price tags, very slight changes in calculation can have dramatic bottom line effects.
When to be wary of the DCF:
The saying has always been the same, garbage in, garbage out, and that’s what we need to look out for. One of the many differences between discounted cash flow modeling, and say, a simple GRM calculation, is a ton of assumptions. And although assumptions aren’t bad at heart, they have the potential to be. The DCF allows us to capture a slew of variables at the mercy of our own expertise, which means our best option at finding and understanding the true value of any commercial property is educating ourselves.
The traditional method of valuation:
We’ve mentioned the shortcomings of the DCF, so let’s find out exactly when and why this analysis method rises to the occasion.
If a property were running exactly as it should and had no indications of changing in the near or far future, there’d be no reason to utilize a cash flow model. We’d simply calculate our total income and subtract our expenses for a net operating income (NOI), which we’d then divide by a capitalization rate (cap rate: the rate of return we’d expect on the income produced by the property), and that’s all folks, we’d have our property value.
For example: A property producing $1,000,000.00 (NOI), in which we’re seeking a 6.25% cap rate, is worth $16,000,000.00. Simple as that.
The Definition of the Discounted Cash Flow Valuation Method (DCF).
If a property is likely to perform differently tomorrow, next month, or five years from now, the previous method will not account for any of these expected fluctuations. Even if we were to average historical property values, which we consider quantifiable facts, that valuation method alone oftentimes is not enough to truly capture the value of a property moving forward. The DCF solves the issue of moving forward by taking future cash flow projections and discounting them to arrive at a present day value.
We achieve a DCF present day value in 3 parts.
1) We record a property’s current income, lease information (or unit mix), and expenses — in other words, all the factual current information of the property. A retail shopping center’s tenants may be recorded in line items similar to these:
2) We make forward assumptions specific to the property, in other words, we create a proforma. How would a property look if it’s fully leased at its most likely market rate? If current leases aren’t reflective of future leases, we adjust them accordingly. And since it’s very unlikely that commercial properties are consistently running at 100% occupancy, we add in a vacancy rate assumption. We further include a likely annual percentage rate increase in rent, expenses, and market costs of tenant improvements and leasing commissions when leases roll over. Here’s an example of captured growth:
3) Finally, we arrive at our most important decision in terms of commercial property value, what required rate of return (cap rate) should we expect for the property? Notice, even a 1% change in the cap rate results in nearly a million dollar change in property value with a $400,000.00 NOI. A sensitivity analysis is a great tool for analyzing the effect of an assumption:
With a discounted cash flow model, the valuation doesn’t stop at a simple property value, we can see exactly what to expect in terms of cash in our pocket and debt service coverage year after year, just to name a few:
Never be fooled again by valuations:
There are a ton of a calculations involved in discounted cash flow modeling, many of which contain mathematics we remember only from school books:
And unless you’re a mathematician, it really does us a disservice to approach DCF modeling this way. Instead, we’re going to finish this resource blog by focusing on the concrete information we deal with as analysts, owners, and brokers during our day to day. Let’s take a look at the most important variables:
If you’re underwriting, receiving, or delivering a discounted cash flow model, the following areas of calculation require 90% of our attention:
The proforma is our first major assumption. Since we’ll be calculating future cash flows based on tenants with certain assumed rent and certain assumed expenses, and even vacancies, if these proforma tenants differ greatly from the current rent roll, we need to know why. There are many reasons differences can occur, and these differences may very well provide the most accurate valuation of a property, but we need to be meticulous in our reasoning.
There are many great tools for analysts to capture true property value, but these tools should always take into account the unique aspects of any specific property. For example, acquiring market rates for an equal grade property in the same market sector is a great way to compare rents, vacancies, expenses, market trends, etc. If the property in questions differs drastically in say tenant rent, we should attempt to isolate the reasoning. The reason may very well be poor management, and if a property were to exchange hands and acquire better management, we’d expect higher rents.
Tenant improvements, leasing commissions, replacement reserves, concessions (to name a few) are those aspects of the proforma less likely to catch an investors attention. It’s very easy to see the differentiate between a current tenant paying $15/SF, and a pro forma assumption of $20/SF, and therefore asking why, but many of these other types of assumptions are listed as a line item without any perspective. For example, this is how we might capture TI/LC:
When a commercial tenant rolls over, these ratios will apply to expenses, undercutting the cash flow during the rollover year, and if TI/LC are not reflective of current market conditions, or historical costs, then we’ll produce a less accurate cash flow. It’s important to know the most likely costs, and sometimes growth rates, of expenses, other income, etc.
As for financing, a major portion of commercial real estate analysis in which we’re only covering the surface in this blog (as far as it pertains to cash flow modeling), we need to know how it changes our bottom line. Once again, cash is the operative term here, and interest as well as principal paid annually will reduce cash in the pocket. A borrower will pay interest based on a spread against say, a 10 year SWAP rate, and if that interest is higher or lower than it should be, our cash flow will change (drastically at times). It’s easy to find an appropriate rate based on similar risk loans. Note, there are many terms that can be applied to lending, but as far as we’re concerned in cash flow modeling, leveraging should be used as a means of showing how far our money can go, and therefore, it’s not typically necessary to apply complicated loan structures (unless you have a very good reason they will exist!).
Required rate of return is our most important assumption. As we showed you earlier, even a percentage change will force drastic changes on the price tag of a million dollar plus property. A cap rate is not an easy thing to come by, but there are a plethora of reasons for choosing a rate. It boils down to the relative risk of investing in a commercial property to say, a very safe treasury bond. What rate of return is someone willing to take in order to compensate for a more risky investment? This rate changes according to the risk of the property, which takes into account location, stability of tenants, comparable properties, market trends, etc. The rate used in a cash flow model may very well change based upon the underwriter of the model. For example, a seller will likely look to increase the value of his/her property by lowering the capitalization rate, arguing the property has less risk. A buyer will likely overcompensate for risk, raising the capitalization rate. There is no definitive way to arrive at a cap rate, but when it happens, it means two parties have negotiated a price. The best we can do is attempt to apply a fair market rate, and even show how sensitive a property’s price is relative to changes in the rate.
We hope you’ve enjoyed our resource on discounted cash flow modeling. If you follow that link, you’ll be directed to our apartment/commercial cash flow models. We also offer a commercial real estate analysis service where we apply our expertise to valuing your property.