One of the biggest problems of real estate valuation practice in the income approach is the noticeable conceptual chaos and lack of uniformity regarding the principles of market analysis of investment transactions, the determination of yields and the application of these figures by valuers in valuations. There is still little awareness of the fundamental importance of choosing the type of cash flow projection and the impact of that choice on the need to use the appropriate type of yields.
Two types of cash flows
It should first be emphasised that the starting point necessary for the preparation of a valuation in the income approach is the valuer’s awareness of the type of income stream projection he intends to use in his valuation. It is only on this basis that an informed decision can be made as to what type of yield (or yields) should be used and at what level they should be. Failure to follow such reasoning results in the outcome of the valuation becoming almost random. We can therefore distinguish between implicit and explicit projection of income streams.
Implicit Cash Flow
Implicit Cash Flow is a projection of income flows, the variability of which in subsequent years is due solely to factors strictly related to the state of the property (and its surrounding), without taking into account projections of future market changes. This is because changes of a market nature are reflected as an element of risk taken into account indirectly, i.e. in the yield
Examples of factors taken into account and not taken into account in implicit cash flow are as follows:
TAKEN INTO ACCOUNT:
– income from lease agreements
– so-called ‘step rents’
– schedule of expiry of leases
– planned capital expenditure
– rent indexation only for the duration of current leases
– void periods after the end of current leases
– so-called “rent-free periods” for new tenants
NOT TAKEN INTO ACCOUNT:
– forecasted changes in market rents (e.g. in view of the expected oversupply of competing properties)
– forecasted changes in operating costs
– indexation of rents after termination of current leases
– other forecasts of market changes
It is worth noting at this point that a certain practice has already taken shape on the Polish real estate market which modifies the classical understanding of implicit cash flow somewhat. It is common for such projections to take into account void periods after the end of current leases and so-called “rent-free periods”. These seem to constitute a kind of “projection” which, in the classical sense, should not be allowed in implicit cash flow. However, the already well-established practice of the Polish real estate market dictates that valuers reflect such a state of affairs in their valuations.
Explicit Cash Flow
In contrast, Explicit Cash Flow is a cash flow projection that allows forecasts of market changes to be introduced directly (explicitly) in the flows themselves and not just indirectly (implicitly) in the yield. It should also be borne in mind that in such cash flow the Residual Value should be estimated using the projected future income from the property and not the current income as with implicit cash flow. In addition, the age and condition of the buildings on the property should also be assessed as expected after the end of the projection period of the income streams and not as it is on the valuation date.
In addition, the fact that certain forecasts are introduced directly into the projection of the income streams and that this is not possible after the end of the projection period (for the calculation of the Residual Value) makes it necessary to use two different rates in the explicit cash flow. These are: Discount Rate (Equated Yield) and Exit Rate (Exit Yield).
The equated yield is the rate that, when used to discount the income flows from the property and the residual value, will give a sum of discounted flows equal to the purchase price of the property.
It is worth noting at this point that a very popular method of determining the discount rate among Polish valuers is the so-called ‘additive method’, which is based on taking as the basis for calculations the rates of return on risk-free investments, which are most often considered to be long-term Treasury bonds. This rate is augmented by various types of premiums reflecting different risks. In particular, a distinction is made here between the risk premium for investing in the property market in general, the risk of investing in a specific local market and the risk premium for investing in a specific property. The latter in particular can be a result of, among other things, the location of the property, its technical condition, the structure of the leases or the reliability of the tenants. Thus, when determining the discount rate in this way, subjective assessments are in fact made and selected risks are included in the rate determined.
Problems with the “additive” method
Unfortunately, this method is definitely overrated. This is because it carries many risks. The multitude of subjective and difficult to justify assumptions in its determination exposes the valuer to the risk of a valuation error and to liability as a result. In particular, questions arise as to which bonds to choose as the basis for further calculations. There are at least several possibilities. Which risks should be taken into account? How much premium should be added for each type of risk?
Furthermore, it should be borne in mind that for some time now (written in 2017) in Poland the base rate for so-called safe investments, e.g. bonds, has been, depending on the current state of the market, 2% – 3%. Meanwhile, typical rates of return for average properties are usually 7% – 8%. It therefore appears that the greater part of the return rate “calculated” in this way is a fully subjective premium. Is it not better, therefore, instead of adding up virtual risk premiums, to take a single subjective decision on the level of the whole rate and justify it with information on recorded rates of return on transactions that have occurred in the market combined with an assessment of the attractiveness of the properties sold relative to the property being valued? Finally, it is worth considering whether there is any correlation at all between the financial market and the property market (see, for example, here). Questions arise, for example, in the context of the negative returns observed in some European countries for some time. Have returns for real estate in these countries also fallen during this time?
There is also another problem, because according to well-established international practice, the additive method is allowed for estimating discount rates only for explicit cash flows. Interestingly, the Polish Interpretative Note on the Income Approach speaks only of implicit cash flow (although it does not call them so), thus allowing the use of the additive method.
Reversionary Yield and Exit Yield
Fortunately, there is slightly less controversy about the Reversionary Yield (typically used in Term&Reversion or dual rate implicit cash flow), which is the quotient of the annual market income (as at the valuation date!) and the property price. In the case of the Exit Yield used in explicit cash flow, it will be the projected (rather than current) market income.
When using implicit cash flow, on the other hand, the situation is much simpler. This is because we use only one yield, the so-called Equivalent Yield, which is a single averaged rate that, when used to discount the annual income flows, calculate the residual value and discount it, will give the sum of the discounted flows equal to the purchase price of the property in question. When analysing the cash flow of a property transacted on the market, the Equivalent Yield can be easily determined using an Excel spreadsheet and the “Goal seek” function.
All Risks Yield
In Polish conditions of limited access to detailed information on real estate investment transactions, the All Risks Yield is of particular significance. It is precisely this type of rate, which on the grounds of the Polish real estate market is simply called the “capitalisation rate”, which is used by real estate appraisers to estimate the value of real estate using the direct capitalisation technique. It is a rate which, by definition, reflects all risks as well as opportunities associated with investing in a given property.
It is worth realising that an investor, when buying a property, considers all the circumstances surrounding the property, including all the foreseeable risks and opportunities that are associated with the investment. Therefore, if he or she has decided to pay a certain amount (price), which in relation to the annual income from the property creates a certain rate, this is the All Risks Yield. This is the resultant of the perception of all risks and opportunities made by the parties to the sale transaction under review.
It is also worth noting that having information on the implicit cash flow of a property as a result of the transaction analysis will result in an All Risks Equivalent Yield.
Now that we have a complete picture of the available types of income stream projections and the ‘co-mingling’ types of yields, it is worth asking ourselves what type of cash flow we should use in our valuations.
Choice of cash flow type
It should be emphasised first and foremost that, correctly applied, both models lead to a correct estimate of value. The decision will therefore rather depend on factors specific to the individual valuer. At this point, however, it is worth being aware of a number of difficulties posed by the use of explicit cash flow. These include:
– the multiplicity of subjective/expert assumptions made by the valuer
– the need to make forecasts (often multi-year) of the many factors directly entering into cash flow
– the need to use at least two rates of return and justify the differences between their levels
– the need to defend all of the above in the event of a valuation challenge
In this light, it is worth realising that projection in the form of implicit cash flow, requires the use of only one rate, usually adopted by the valuer on the basis of an analysis of the market, including yields for similar properties and the differences between those properties and the property being valued and. The passage of time and trends in the change of rates in the market between the dates of the transactions analysed and the valuation date should also be taken into account. The yields observed in the market are, moreover, the resultant of the perception of all risks and opportunities of the property in question, as assessed by specific market participants who certainly had much more accurate information about the property being purchased than the valuers. It is also not uncommon for them to have engaged the services of specialists in the transaction, e.g. lawyers, engineers, etc. The task remaining for the valuer, therefore, is simply to take into account the differences between similar properties and the property being valued and to maintain methodological order in the selection of the types of return for the type of cash flow.
The most important conclusion from the above considerations is therefore the necessity to build in valuations of cash flow projections of the same type of income stream projections as in the market transactions analysed (the famous: “As you value, so shall you devalue!”). It is also unacceptable to mix the types of yields used. Their selection must always harmonise with the type of cash flow used.
 A. Baum, C. Manville, N. Nunnington, D. Mackmin, ‘The Income Approach to Property Valuation’, 6th ed. Routledge 2014
 N. Crosby, ‘Definition of commercial property equivalent yield’, Financial Times
 The function can be found on the ‘Data’ tab, in the ‘Data Tools’ group, under the ‘Simulation Analysis’ menu. We discount the income flows of each year’s cash flow with any temporarily assumed rate of return. After selecting “Goal seek” from the drop-down menu, a menu tab will appear. In the ‘Set cell’ field, indicate the cell containing the formula for the sum of all PV DON and PV Residual Value. In the “Value” field, enter the transaction price. In the “Change cell” field, indicate the cell in which the provisionally adopted yield is entered. After pressing OK. Excel will select the yield by trial and error so that the sum of the discounted flows and the residual value equals the transaction price.
The article appeared in the quarterly magazine “Rzeczoznawca Majątkowy” in 2017.