Discounted cash flow: accounting for uncertainty

Valuation is the process of estimating price. The methods used to determine value attempt to model the thought processes of the market and thus estimate price by reference to observed historic data. This can be done using either an explicit model, that models the worth calculation of the most likely bidder, or an implicit model, that that uses historic data suitably adjusted as a short cut to determine value by reference to previous similar sales. The former is generally referred to as the Discounted Cash Flow (DCF) model and the latter as the capitalisation (or All Risk Yield) model. However, regardless of the technique used, the valuation will be affected by uncertainties. Uncertainty in the comparable data available; uncertainty in the current and future market conditions and uncertainty in the specific inputs for the subject property. These input uncertainties will translate into an uncertainty with the output figure, the estimate of price. In a previous paper, we have considered the way in which uncertainty is allowed for in the capitalisation model in the UK. In this paper, we extend the analysis to look at the way in which uncertainty can be incorporated into the explicit DCF model. This is done by recognising that the input variables are uncertain and will have a probability distribution pertaining to each of them. Thus buy utilising a probability-based valuation model (using Crystal Ball) it is possible to incorporate uncertainty into the analysis and address the shortcomings of the current model. Although the capitalisation model is discussed, the paper concentrates upon the application of Crystal Ball to the Discounted Cash Flow approach.

Pricing the options inherent in leased commercial property: a UK case study

This paper sets out the findings of a group of research and development projects carried out at the Department of Real Estate & Planning at the University of Reading and at Oxford Property Systems over the period 1999 – 2003. The projects have several aims: these are to identify the fundamental drivers of the pricing of different lease terms in the UK property sector; to identify current and best market practice and uncover the main variations in lease terms; to identify key issues in pricing lease terms; and to develop a model for the pricing of rent under a variety of lease variations. From the landlord’s perspective, the main factors driving the required ‘compensation’ for a lease term amendment include expected rental volatility, expected probability of tenant vacation, and the expected costs of tenant vacation. These data are used in conjunction with simulation technology to reflect the options inherent in certain lease types to explore the required rent adjustment. The resulting cash flows have interesting qualities which illustrate the potential importance of option pricing in a non-complex and practical way.

The impact of energy performance certificates on the rental and capital values of commercial property assets: some preliminary evidence from the UK

This paper focuses on the effect of energy performance ratings on the capital values, rental values and equivalent yields of UK commercial property assets. Of which a small number are also BREEAM rated, the study is based upon 708 commercial property assets held in the IPD UK Universe drawn from across all PAS segments. Incorporating a range of controls such as unexpired lease term, vacancy rate and tenant credit risk, hedonic regression procedures are used to estimate the effect of EPC rating. The study finds no evidence of a strong relationship between environmental and/or energy performance and rental and capital value. Bearing in mind the small number of BREEAM rated assets, there was a small but statistically significant effect on equivalent yield only. Similarly, there was no evidence that the EPC rating had any effect on Market Rent or Market Value with only minor effects of EPC ratings on equivalent yields. The preliminary conclusion is that energy labelling is not yet having the effects on Market Values and Market Rents that provide incentives for market participants to improve the energy efficiency of their commercial real estate assets.

The appraisal of data centres: deconstructing the cash flow

This paper analyses the appraisal of a specialized form of real estate - data centres - that has a unique blend of locational, physical and technological characteristics that differentiate it from conventional real estate assets. Market immaturity, limited trading and a lack of pricing signals enhance levels of appraisal uncertainty and disagreement relative to conventional real estate assets. Given the problems of applying standard discounted cash flow, an approach to appraisal is proposed that uses pricing signals from traded cash flows that are similar to the cash flows generated from data centres. Based upon ‘the law of one price’, it is assumed that two assets that are expected to generate identical cash flows in the future must have the same value now. It is suggested that the expected cash flow of assets should be analysed over the life cycle of the building. Corporate bond yields are used to provide a proxy for the appropriate discount rates for lease income. Since liabilities are quite diverse, a number of proxies are suggested as discount and capitalisation rates including indexed-linked, fixed interest and zero-coupon bonds.

Valuation and arbitrage

The use of discounted cash flow (DCF) methods in investment valuation and appraisal is argued by many academics as being rational and more rigorous than the traditional capitalisation model. However those advocates of DCF should be cautious in their claims for rationality. The various DCF models all rely upon an all-encompassing equated yield (IRR) within the calculation. This paper will argue that this is a simplification of the risk perception which the investor places on the income profile from property. In determining the long term capital value of a property an 'average' DCF method will produce the 'correct' price, however, the individual short term values of each cash-flow may differ significantly. In the UK property market today, where we are facing a period in which prices are not expected to rise generally at the same rate or with such persistence as hitherto, investors and tenants are increasingly concerned with the down side implications of rental growth and investors may indeed be interested in trading property over a shorter investment horizon than they had originally planned. The purpose of this paper is therefore to bring to the analysis a rigorous framework which can be used to analyse the constituent cash flows within the freehold valuation. We show that the arbitrage analysis lends itself to segregating the capital value of the cash flows in a way which is more appropriate for financial investors

Rental depreciation and capital expenditure in the UK commercial real estate market, 1993–2009

This paper identifies the long-term rental depreciation rates for UK commercial properties and rates of capital expenditure incurred to offset depreciation over the same period. It starts by reviewing the economic depreciation literature and the rationale for adopting a longitudinal method of measurement, before discussing the data used and results. Data from 1993 to 2009 were sourced from Investment Property Databank and CB Richard Ellis real estate consultants. This is used to compare the change in values of new buildings in different locations with the change in values of individual properties in those locations. The analysis is conducted using observations on 742 assets drawn from all major segments of the commercial real estate market. Overall rental depreciation and capital expenditure rates are similar to those in other recent UK studies. Depreciation rates are 0.8% pa for offices, 0.5% pa for industrial properties and 0.3% pa for standard retail properties. These results hide interesting variations at a segment level, notably in retail where location often dominates value rather than the building. The majority of properties had little (if any) money spent on them over the last 16 years, but those subject to higher rates of expenditure were found to have lower depreciation rates.

The impact of NTFP sales on rural households’ cash income in India’s dry deciduous forest

In recent years, researchers and policy makers have recognized that nontimber forest products (NTFPs) extracted from forests by rural people can make a significant contribution to their well-being and to the local economy. This study presents and discusses data that describe the contribution of NTFPs to cash income in the dry deciduous forests of Orissa and Jharkhand, India. In its focus on cash income, this study sheds light on how the sale of NTFPs and products that use NTFPs as inputs contribute to the rural economy. From analysis of a unique data set that was collected over the course of a year, the study finds that the contribution of NTFPs to cash income varies across ecological settings, seasons, income level, and caste. Such variation should inform where and when to apply NTFP forest access and management policies.

Which factors drive rental depreciation rates for office and industrial properties?

As new buildings are constructed in response to changes in technology or user requirements, the value of the existing stock will decline in relative terms. This is termed economic depreciation and it may be influenced by the age and quality of buildings, amount and timing of expenditure, and wider market and economic conditions. This study tests why individual assets experience different depreciation rates, applying panel regression techniques to 375 UK office and industrial assets. Results suggest that rental value depreciation rates reduce as buildings get older, while a composite measure of age and quality provides more explanation of depreciation than age alone. Furthermore, economic and local real estate market conditions are significant in explaining how depreciation rates change over time.