Journal of Property Investment & Finance

The discounted cash flow model for property valuations: quarterly cash flows
Nick French
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Nick French, (2013),"The discounted cash flow model for property valuations: quarterly cash flows", J ournal
of Property Investment & Finance, Vol. 31 Iss 2 pp. 208 - 212
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Nick French, (2013),"The discounted cash flow model for property valuations: quarterly in advance cash
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Nick French, (2012),"The discounted cash flow method for property appraisals", J ournal of Property
Investment & Finance, Vol. 30 Iss 3 pp. -
Nick French, (2013),"Reversionary freehold valuations: over#rented cash flows by spreadsheet", J ournal of
Property Investment & Finance, Vol. 31 Iss 3 pp. 298-306
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EDUCATION BRIEFING
The discounted cash ow model
for property valuations:
quarterly cash ows
Nick French
Department of Real Estate and Construction,
Oxford Brookes University, Oxford, UK
Abstract
Purpose There are three approaches to valuation: cost, market and income. As a subset to the
income approach, the investment method looks at the pricing of assets that produce income over an
investment holding period. The discounted cash ow (DCF) technique or model can be developed to
look at the cash ows on a quarterly basis to reect the actual receipt of the cash ows. The aim of this
paper is to give an overview of the DCF quarterly model.
Design/methodology/approach This education brieng is an overview of the DCF quarterly
model.
Findings The DCF quarterly model can be seen to produce estimates of market value.
Practical implications As the use of DCF is developed and expanded, it is useful to be able to
model the cash ows appropriately.
Originality/value This is a review of existing models.
Keywords Market value, Quarterly cash ows, Discounted cash ow, Real estate, Cash ow
Paper type General review
Introduction
In an earlier Education Brieng (French, 2012), it was shown that an explicit
discounted cash ow (DCF) valuation involves projecting estimated cash ows over
an assumed holding period, plus an exit value at the end of that period, usually arrived
at on a conventional all-risk yield (ARY) basis (exit yield). The cash ow is then
discounted back to the present day at a discount rate that reects the perceived level of
risk. This method does the same as any valuation method, it is the process of
determining market value. An estimation of the price of exchange in the market place.
Valuation example annual in arrears
In England[1], rents are actually received quarterly in advance on set quarter days[2].
That is the reality. Rents received quarterly in advance. Yet, the UK commercial
property market has traditionally used annual (nominal) market benchmarks such
as the ARY based on the assumption that rents are received annually in arrears.
Indeed, The Mallinson Report (RICS, 1994, 2011) commented on this particular point
stating:
[. . .] are we wise to continue using tables which assume rent to be received annually in arrears
when the client knows that he receives it quarterly in advance.
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1463-578X.htm
Journal of Property Investment &
Finance
Vol. 31 No. 2, 2013
pp. 208-212
qEmerald Group Publishing Limited
1463-578X
DOI 10.1108/14635781311302618
JPIF
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But, the point is that it does not matter when undertaking implicit valuations. Implicit
models, by their nature, are short cuts. They imply lots of assumptions in one yield
(ARY) that produces a multiplier that prices the rent. That ARY, even though it is
expressed as an annual in arrears rate, it is implying/reecting the reality that rents are
received quarterly in advance. In simple terms, the ARY is slightly lower than it would
be otherwise so that the multiplier (1/ARY) is slightly higher and the price
estimation/value corresponding higher to reect the advantage of a quarterly in
advance cash ow. Thus, using the same example as in the previous Education
Brieng (French, 2012), the cash ow (Example 1) was presented as an annually in
arrears cash ow to be valued implicitly (Example 1A) and explicitly[3] (Example 1B).
The following example was used and, as can be seen, both valuation techniques
produce the same capital value of 12.5 m before costs. This is the estimate of price
that investors would pay for this investment knowing that the rents are actually
received quarterly in advance.
Example 1
Market rent (MR) 1,000,000 (per annum payable quarterly in advance).
Lease ten years.
ARY 8 per cent (from market evidence).
Target rate 10.75 per cent (risk free rate 4.75 per cent at that point in time plus
4 per cent market risk plus 2 per cent property/covenant risk).
Rent reviews ve yearly.
Annual growth 3.2 per cent calculated see French (2012).
A. Implicit annually in arrears
MR 1,000,000.
YP perp @ 8.00 per cent 12.50.
Market value 12,500,000.
B. Explicit DCF (annual cash ows down the page)
This model uses annual in arrears assumptions and assumes a sale at end of lease at an
exit yield equivalent to todays ARY (Table I).
Valuation example quarterly in arrears
Before looking at quarterly in advance (Q in A) DCF valuations, we will look at
modifying the cash ow into quarterly periods but still in arrears. The reason for
this extra step in the transition to Q in A is to discuss the ARY as an annual and
quarterly rate.
There is an issue in the valuation and the conversion of the annual in arrears
benchmark to a quarterly in arrears yield for the explicit DCF technique.
There is no issue with the implicit approach. The rent gets divided by 4, the ARY is
also divided by 4 and the valuation self adjusts as the YP multiplier (obviously, being
the reciprocal of the ARY) increases by the same magnitude. The valuation become as
illustrated in Example 2.
Education
brieng
209
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Example 2
Quarterly MR 250,000 (payable quarterly in advance).
Lease ten years.
Quarterly ARY 2 per cent (from market evidence 8 per cent/4).
Quarterly target rate 2.6875 per cent (10.75 per cent/4).
Rent reviews ve yearly.
Annual growth 3.2 per cent calculated see French (2012).
A. Implicit quarterly in arrears
MR 250,000.
YP perp @ 2.00 per cent 50.
Market value 12,500,000.
The implicit valuation can also be adjusted to reect quarterly in advance receipts too
and that will be considered in the next Education Brieng in this series.
That said, there is a strong argument that adjusting implicit models is superuous.
The implicit model is a short cut and, as such, it should give an estimate of prices in its
simplest form. To use the analogy of taking a short cut across the eld, the implied
annual in arrears model (Example 1A) is a straight line between points X and Y. Any
adjustment to the model (even is mathematically correct) means that you are now
walking from X to Y in a zig-zag. This seems to be a superuous.
B. Explicit DCF (annual cash ows down the page)
This model uses quarterly in arrears assumptions and assumes a sale at end
of lease at an exit yield equivalent to todays ARY (inated valuation of above)
(Table II).
As can be seen, this is still a good estimate of price but by using the simple annual
target rate divided by 4 produces (10.75 per cent/4 2.6875 per cent) slightly lower
valuation. 12.394 m rather than 12.5 m.
Year Rent () Capital () Cash ow () PV @ 10.75 per cent PV ()
1 1,000,000 1,000,000 0.903 902,935
2 1,000,000 1,000,000 0.815 815,291
3 1,000,000 1,000,000 0.736 736,154
4 1,000,000 1,000,000 0.665 664,699
5 1,000,000 1,000,000 0.600 600,180
6 1,170,415 1,170,415 0.542 634,275
7 1,170,415 1,170,415 0.489 572,709
8 1,170,415 1,170,415 0.442 517,118
9 1,170,415 1,170,415 0.399 466,924
10 1,170,415 17,123,390
a
18,293,805 0.360 6,589,716
Market value 12,500,000
Notes:
a
The sale price at exit is the projected rent for year 11 (1,369,871) YPed at the exit yield of
8 per cent; this is 1,369,871 12.5 17,123,390 Table I.
JPIF
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An alternative to using the quarterly nominal rate is to use the effective quarterly
(in arrears) rate of 2.5855 per cent ( (1 (e))^(1/4) 2 1). This produces a slightly
higher answer of 12.75 m.
Both are approximations that come about because comparables for the ARY (k) and
target rate (e) are analysed on an annual basis and then adjusted (crudely) into
quarterly gures.
A more robust approach can be adopted when looking at Q in A valuations and this
will be illustrated and explained in the next Education Brieng in this series.
Quarters Rent () Capital () PV @ 2.6875 per cent PV ()
1 250,000 0.9738 243,457
2 250,000 0.9483 237,085
3 250,000 0.9235 230,881
4 250,000 0.8994 224,838
5 250,000 0.8758 218,954
6 250,000 0.8529 213,223
7 250,000 0.8306 207,643
8 250,000 0.8088 202,208
9 250,000 0.7877 196,916
10 250,000 0.7671 191,763
11 250,000 0.7470 186,744
12 250,000 0.7274 181,857
13 250,000 0.7084 177,097
14 250,000 0.6898 172,462
15 250,000 0.6718 167,949
16 250,000 0.6542 163,553
17 250,000 0.6371 159,273
18 250,000 0.6204 155,104
19 250,000 0.6042 151,045
20 250,000 0.5884 147,092
21 292,604 0.5730 167,653
22 292,604 0.5580 163,265
23 292,604 0.5434 158,992
24 292,604 0.5291 154,831
25 292,604 0.5153 150,779
26 292,604 0.5018 146,833
27 292,604 0.4887 142,990
28 292,604 0.4759 139,248
29 292,604 0.4634 135,603
30 292,604 0.4513 132,054
31 292,604 0.4395 128,598
32 292,604 0.4280 125,233
33 292,604 0.4168 121,955
34 292,604 0.4059 118,763
35 292,604 0.3953 115,655
36 292,604 0.3849 112,628
37 292,604 0.3748 109,680
38 292,604 0.3650 106,810
39 292,604 0.3555 104,015
40 292,604 17,123,390 0.3462 6,028,996
Market value 12,393,724
Table II.
Quarterly full
DCF explicit
Education
brieng
211
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Notes
1. Scotland, Northern Ireland and Eire all still use quarter days but on different dates.
2. The English quarter days (also observed in Wales and the Channel Islands) are: Lady Day
(25 March), Midsummer Day (24 June), Michaelmas (29 September) and Christmas
(25 December).
3. The explicit valuation technique was presented in three formats: (1) a cash ow blocked
in periods equivalent to the rent review period, (2) an annual cash ow vertical (down the
page) layout and (3) an annual cash ow horizontal (across the page) layout.
References
French, N. (2012), The discounted cash ow method for property appraisals: transparency,
application and appropriateness, Journal of Property Investment & Finance, Vol. 30 No. 3,
pp. 321-7.
RICS (1994), Commercial property valuations, Mallinson Report, Royal Institution of Chartered
Surveyors, London, p. 34.
RICS (2011), Discounted Cash Flow for Commercial Property Investments, RICS Guidance Note,
RICS Practice Standards, RICS, London.
Further reading
French, N. and Cooper, R. (2000), Investment valuation models: annually in arrears data in
quarterly in advance cash ows, Journal of Property Investment & Finance, Vol. 18 No. 2,
pp. 235-8.
Corresponding author
Nick French can be contacted at: nick.french@brookes.ac.uk
JPIF
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This article has been cited by:
1. Nick French. 2013. The discounted cash flow model for property valuations: quarterly in advance cash
flows. Journal of Property Investment & Finance 31:6, 610-614. [Abstract] [Full Text] [PDF]
2. Nick French. 2013. The discounted cash flow model for property valuations: quarterly in advance cash
flows. Journal of Property Investment & Finance 31:6, 610-614. [CrossRef]
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