Implications of the New DCF Method

Q&A with Professor Neil Crosby, Henley Business School and Maria Wiedner, CEO Cambridge Finance.

I am part of the valuation review committee and I think one of the basic terminologies are centred around the method and model. Also traditional instead of implicit. How would you think the review should address this?

Neil: The definitions of what constitutes an Approach, Method or Model has been discussed in some detail in the working group prompted to some extent by comments through the review group and by the Chair of the RICS Valuation EWG. The final application of this to the DCF statement has yet to be agreed but I don’t foresee much of a problem with this in the final reckoning. I don’t like “traditional” and “implicit” describes the model better, but it feels clunky and I am not sure there is a phrase that would keep everybody happy? So implicit better than traditional, but can we find a better description for the final draft?

What do the investors want regarding valuation method used? Was this quest to use DCF rather than the traditional method driven by their demands? I am not aware it was

Maria: According to the RICS Independent Review, by Peter Pereira Gray, Dec 2020, investors want more information about the make-up of the value, i.e. more transparency in how values are derived and communicated.

Neil: I was under the impression that the review was to some extent client led, and agree with Maria that there is a clear call for more transparency behind both methods and the data they rely on. Valuers in general don’t appear keen to change their methods/models and, given the transparency of data in the UK, have a legitimate argument for using cap rate comparisons in a large number of occasions. But they need to communicate to clients what the risks hidden in the cap rat are. In my opinion, that should be standard whether the clients want it or not. It is also the justification for not using a DCF model direct, which was another of Peter Pereira Gray’s recommendations (he suggested that all valuers should be asked to justify not using DCF).

An implicit model can always be, and in my opinion should always be, characterised as a function of target rate, growth rate and cap rate so the assumptions behind the price are clear.

Do you think that overall confidence in a market (the confidence multiplier in behavioural economics) can sustain prices long enough to ride out a potential bubble burst? Especially where all valuers are saying the same thing and supporting the high prices? Is it more prudent not to scaremonger?

Maria: Economist John Maynard Keynes once said that “markets can stay irrational longer than you can stay solvent”. Valuers look at transactional evidence, so it is based on historic data points, hence what if prices are high, they stay high for a while, and once they start to go down, then they all go down. Market values are backward looking, rather than forward looking. It is never prudent to scaremonger, but it is prudent to warn of future risks.

Neil: I feel a rant coming on here!! Scaremongering is often telling the truth and we need a lot more of it. The lesson of 2007 is clear and unambiguous. There are many incentives in our financial markets for individuals NOT to behave prudently. While we have the spectre of ordinary taxpayers picking up the bill while those who made significant gains in the boom being paid off and not paying it all back, I would support the scaremongers every time. Better a correction from markets 20% overvalued early in the boom based on the “scaremongers” calling the market out, than riding the wave (a well-known phenomenon in cycles behavioural research) until the bubble bursts at 40% overvalued. The difference in loan defaults at those two points is massive. And which wave was ever “ridden out”. The crashes are actually quite reserved and normally get us back to some sort of equilibrium and are corrections rather than massive over-corrections. As you can see, fundamentally disagree with the suggestion (and for all I know the questioner may also be playing devil’s advocate). I would go as far to say that talking markets up has been the root of many problems in the three recessions that I have lived through in 1973, 1990 and 2007. Give me objective commentary every time.

How is the discount rate derived?

Maria: For market values, it would be the IRR that will make the NPV = 0, or the Purchase Price = PV of Future Cash Flows.

Neil: We have tried in the RICS statement on DCF to give a range of possibilities. It is not for us to tell everybody precisely what to do or set a level. Some respondents want us to do that. But none of us have a monopoly on the truth so the valuers should be able to pick their preferred approach. We are providing a suggested menu. It also depends on whether you are doing a market value or an investment value. My preference is for a nominal risk-free rate plus risk premium approach and believe in a range of risk premia for a range of property types/locations, etc. It also depends upon how detailed the other inputs are as if these are limited then there is an element of the other inputs being hidden within the discount rate. In investment value it is legitimate to use specific investor’s rates but not in market value. I would also hope that performance measurement systems would start to collect or calculate some basic cash flow indicators as they already do in Sweden. Finally, to tie into Maria’s answer, I would see discount rates being extracted from transactions as IRRs but the analysis of transactions using cash flow models is an essay in itself. There is a fine line in this particular RICS guidance between guidance note and textbook and I think the consultation draft will attract some feedback as to how it fits into these two characterisations.

Where lenders/investors are requiring investment into sustainability capex for an asset – this alone will negatively impact the DCF output if no shift in occupier premium paid on rents? In macro context of hitting sustainability targets, how will the market make sure landlords are not penalised for making such investments?

Maria: The capex required for sustainability should in theory increase the market value of the property, so there isn’t a penalty as such.

Neil: I don’t see this as being much different from normal refurbishment/redevelopment decision making within DCF valuations. It comes into the depreciation arguments around DCF valuations and how you deal with rents depreciating through time, and then how you deal with the costs and rent increases/exit yield changes coming out of the actual expenditure.
Thanks to both / all for this, a long debate – seems to me amazing that anyone is not using DCF methodology, but then I have double-Maths A-Level, Maths A/O-Level and Maths O-Level, all at A Grade, so perhaps easier for some than others…

Maria: It is very unusual for valuers to have a strong mathematical background and the lack of mathematical understanding is coming to light now that we need to talk about more complex calculations rather than just diving one number by another. Compounding is particularly an issue, but simple weighted averages are not well understood. We will certainly need to skill up the next generation of valuers so they do not just see a number but they can interpret what the number means and the risks around it.

Neil: Better than my maths certainly! But I don’t think maths is the issue. There is so much technology around that, although desirable, you don’t have to be able to do any of the maths to undertake DCF valuations. I think we do have some major deficiencies in the debates around the practical matters such as the question about discount rates. There are forecasting accuracy issues, depreciation and obsolescence synergies, holding periods and exit values and for each, there are a myriad of ways of approaching getting to a number. Having said all of that, I do not think that a movement to DCF is a movement towards less consistency and accuracy, quite the opposite. The more transparent the model, the more likely it is to show up discrepancies and enable a more considered outcome to emerge. I live in hope.