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Marcin Malmon


Szczerze o nieruchomościach

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Little known facts about DCF

Since there is a chance that we will soon start to officially ‘recognise’ the ‘explicit cash flow’ commercial property valuation technique in Poland, I will today share my observation on the practice of its application in Poland so far.

In a nutshell, this variation of DCF allows for forecasts of expected future changes in the market to be factored into cash flow, as opposed to ‘implicit cash flow’, where these changes are factored…indirectly in the yield.

Well, on a number of occasions in recent years I have seen DCF projections with forecasts that differentiate between the discount rate, usually estimated at the market capitalisation rates at the valuation date, and the capitalisation rate used to calculate the residual value (the so-called exit yield). There is nothing wrong with this and indeed in most cases this should be the case. However, it is puzzling that most often the exit yield is taken at a lower level than the market yield at the valuation date in such valuations. Does this make sense and does anyone else remember why they do this?

When asked why this is the case, valuation authors most often indicate that the exit yield is lower than today’s level because they are expressing an expectation of future income growth in the property after the end of the forecast period.

A slightly better argument is that some income growth of e.g. 1.5% – 2% has been explicitly projected for the cash flow projection period. Thus, the projection assumes a bit more optimism, so the discount rate for this period should also be higher than the exit yield to reflect the higher risk of generating such a growing income over the projection period. This explanation may be reasonable insofar as the valuation differentiates between the level of current yields and the assumed discount rate to show that the discount rate does not include an element reflecting future income increases, which are after all shown in the cash flow projection itself.

However, the question arises:

Why the widespread belief in future increases in property income?

I suggest having a look at the chart below showing the changes in the level of office rents in Warsaw (prime headline rents) in the period 1995 – 2015. Of course, this is already heavily outdated data, but it represents quite a large, 20-year period of the Polish real estate market. Therefore, I think they are sufficient for my general considerations.

Source: Polish Properties

As can easily be seen, in most years during the period under review, rents fell or at best did not rise. As one can easily guess, it was the compression of yields that helped to maintain office property values. The dashed lines in the graph represent the projections of implied rent increases described above, in this case 2% per annum. Looking at the graph above, it is therefore worth reiterating the question of whether, with such historical rental levels, it is really reasonable to assume continued increases in property yields in the future, and thus exit yields lower than the capitalisation rates at the valuation date?

So, what are the little known facts?

The following part of this text will be somewhat speculative and subjective in nature, but not devoid of factual basis, which I learnt in the course of my conversations with those who shaped the Polish school of valuation at its inception.

It is no secret that the aforementioned Polish school of real estate valuation, in terms of commercial property valuation, draws heavily from the British school. This is no coincidence, as the first professional real estate valuation teams in large international companies in Poland were often formed by Brits.

In the absence of historical data from the Polish property market, which was only just emerging, it was natural to shape the valuation methodology and set of typical assumptions for valuations based on the analogy of how they did it in the UK. There, indeed, taking exit yields at levels below discount rates was a natural practice, as it was also reasonable to assume immanent increases in property income in the future.

However, this was due to the peculiar UK market practice of very long leases (often 30, 50 years) providing for periodic rent reviews. During the period of such a review, the parties to the contract usually appointed an expert who, for example, every 5 years determined a new level of market rent and if this was higher than the contract rent then the contract rent was adjusted. The important point, however, is that the contractual rent could only be revised upwards. Thus, the likelihood of income increases in the property in the future was very high, compounded by more economic factors of that market.

The passage of time has shown that Polish market practice has not moved in this direction and Polish leases have mostly been shorter and have not included a rent review mechanism similar to that in the UK. It is true that a practice of “inflationary” rent valorisation “only upwards” emerged, but with much shorter typical lease periods (often 3 or 5 years) after the end of the leases, the re-letting of a given space often took place at a much lower rent level, and this is exactly what the chart above shows.

My impression is that, because the vast majority of property valuation teams no longer include those pioneers who introduced the UK practice of explicit DCF rate levels, few now remember and note the lack of justification for its continuation.

To make matters worse, the Polish school of valuation has for years contested “explicit cash flows”, so Polish valuers to this day have not lived to see described indigenous principles of good practice in the application of this particular DCF model. They were condemned to foreign language literature or just old practices brought to Poland from outside. Perhaps the adoption of a draft of a new methodological guidance note on the income approach will change this, although this is still not a foregone conclusion.

Then, how it should be?

Of course, it is impossible to generalise and point to one way of doing things that is right for all properties. Such mechanical thinking is one of the most dangerous things for any commercial property valuer.

Nevertheless, if one wanted to indicate in some generalised way the practice that is most likely to be appropriate in most cases it is the opposite of that described in the introduction. In a nutshell, in most cases the exit yield should be higher than the market level at the valuation date because of the higher risk of predicting income levels in the relatively distant future (Remember that in ‘explicit cash flow’ the market rent for calculating the residual value is the future, projected rent and not today’s rent at the valuation date) and because of the age of the property being valued, which we should take into account when considering the investment risk for that property beyond the cash flow projection period.

Finally, to indicate that this is not just my isolated opinion, I quote in the original the contents of paragraph 7.42 of the Valuation Methodology chapter of the latest edition of the European Valuation Standards (EVS 2020).

„Typically, investors either assume the capitalisation rate at the end of the hold period (exit yield/future capitalisation rate) to be equal to the capitalisation rate prevailing at the date of valuation, or they assume a capitalisation rate on exit that is higher than the current capitalisation rate to account for the uncertainty of future cash flows expected to be received by the property over the hold period and because of the depreciation of the building over the hold period.”

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