Sustainable Property Investment and Valuation

Discounted Cash-Flow method

Limitations of the ARY method

 “The ARY is simply a ratio between income and capital

value. Because income and capital value are expected to
change (usually grow) over the holding period of an
investment, investors are often prepared to accept a lower
return (initial yield) at the start of the investment in
expectation of higher returns later on. Rather than attempt
to predict how income and value might change in the
future, ARY investment valuation techniques capitalise the
current rent at an all-risks yield (derived from comparable
evidence) which is lower than the rate of return that an
investor expects to receive because it implies future rental
income and capital growth expectations.”
Wyatt, P., (2013). Property Valuation,
2nd ed. Oxford: Wiley Blackwell, p. 135.
The DCF approach

 The Discounted Cash-Flow (DCF) method assumes that “the

value of an asset is the present value of the expected
cashflows on the asset, discounted back at a rate that
reflects the riskiness of these cashflows.”
Damodaran, A., 2005, Valuation approaches and metrics: a
survey of the theory and evidence, Found. Trends Finance,
1(8), 693–784. http://doi.org/10.1561/0500000013.

 Between the mid-sixties and the early seventies, the DCF

approach has been progressively adopted in the theory and
practice of property investment valuation.
Key variables

 CAPEX, Capital Expenses (costs related to building, acquiring

or upgrading tangible assets)
 OPEX, Operating Expenses (materials, labor, and machinery
used to make a product or deliver a service)
 Overhead Expenses (pertain to general functions, e.g.,
administrative overhead, utilities, insurance, and so forth)
 Operating Income

 CF, Cash Flow = Operating Income

- CAPEX - OPEX - Overhead Expenses
Key variables

 For a given period of time (t = 0, 1, … n, where n is the

project life-cycle) and a given discount rate (r, the interest
rate used for discounting purposes), the value (V) of a
project is as follows:
 V = CF1 / (1 + r)1 + CF2 / (1 + r)2 + … CFn / (1 + r)n

 In brief
 V = t=1..n CFt / (1 + r)t
Valuation perspectives
 The investors
 Cash Flow: Levered
 Discount rate: Cost of equity (ke)
 Indicators: Net present value (Npv)
Internal rate of return (Irr)
calculated on the levered cash flow and discounted using ke

 The project ‘as a whole’

 Cash Flow: Unlevered
 Discount rate: Weighted average cost of capital (wacc)
 Indicators: Net present value (Npv)
Internal rate of return (Irr)
calculated on the unlevered cash flow and discounted using wacc

 The lenders
 Indicators: Annual debt service cover ratio (Adscr)
Loan life cover ratio (Llcr)
Levered vs Unlevered cash flows

 Levered cash flow  Unlevered cash flow

 - Equity  - CAPEX
 - OPEX  - OPEX
 - Overhead  - Overhead
 + Income  + Income
 - Debt reimbursement

 Financing sources
 Equity = CAPEX * x%
 Debt = CAPEX * (1 – x%)
Cost of equity

 The discount rate as the cost of equity (expected rate of

return on equity) is estimated as follows
 ke = rrf +  * rrp

 where
 rrf is the risk-free rate, namely, the best rate of return of the
investments characterized by a near-zero risk
 rrp is the risk-premium rate, namely, the rate of return when
taking the average market risk
  is the parameter that represents the exposure of the project
to the market risk
Cost of equity
 Data sources
 rrf
 Yield of Treasury Bonds, see, for instance:
 http://www.dt.tesoro.it/en/debito_pubblico/dati_statistici/rendime
nti_composti_lordi_all_esmissione.html /
https://www.bundesbank.de/en/statistics/money-and-capital-
markets/interest-rates-and-yields/tables-793728 /
https://www.treasury.gov/resource-center/data-chart-
center/interest-rates/pages/textview.aspx?data=yield
 rrp and 
 Specific studies on risk premiums, betas, and discount rate
estimation, see, for instance:
 http://people.stern.nyu.edu/adamodar/New_Home_Page/data.ht
ml /
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/
ctryprem.html /
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/
Betas.html
Weighted average cost of capital

 The discount rate as the weighted average cost of capital

(i.e., an entity’s cost of capital in which each category of
capital is proportionately weighted) is estimated as follows
 wacc = ke * [E / (E + D)] + kd * [D / (E + D)]

 where
 ke is the cost of equity E (expected rate of return on equity)
 kd is the cost of debt D
Feasibility indicators: NPV and IRR

 Feasibility indicators
 NPV (Net Present Value), it is given by the difference
between the present value of cash inflows and the present
value of cash outflows over the period of analysis
 NPV = t=1..n NCFt / (1 + r)t
 where NCFt is the difference between cash inflows and cash
outflows in a given period t, and r is the discount rate (ke or
wacc)
 IRR (Internal Rate of Return), it is defined as the discount
rate r that makes the NPV equal to zero, thus it is a metric
that represents the profitability of an investment
 t=1..n NCFt / (1 + r)t = 0
NPV and IRR: an example

Discount rate
10.000%
Year Net cash flow Discount factor Discounted cash flow
0 ‐15,000 1.0000 ‐15,000
1 4,000 0.9091 3,636
2 4,000 0.8264 3,306
3 4,000 0.7513 3,005
4 4,000 0.6830 2,732
5 4,000 0.6209 2,484
Npv 163

Discount rate
10.425%
Year Net cash flow Discount factor Discounted cash flow
0 ‐15,000 1.0000 ‐15,000
1 4,000 0.9056 3,622
2 4,000 0.8201 3,280
3 4,000 0.7427 2,971
4 4,000 0.6726 2,690
5 4,000 0.6091 2,436
Npv 0
Feasibility indicators: cover ratios

 Cover ratios are the metrics used to represent the ability of

a project and its cash flows to repay the debt in full within
a certain period of time
 LLCR (Loan Life Cover Ratio), it is calculated as the ratio
between the net present value (discounted at a rate r = wacc)
of operating cash flows generated between the date of
calculation and the debt's maturity year and the amount of
debt existing as of the calculation date
 ADSCR (Annual debt service cover ratio), it is a measure
of the short term ability to repay the debt and is calculated as
the ratio between operating cash flows and debt repayment
for each year until the debt's maturity year
Feasibility indicators: cover ratios
Project valuation

 If NPV ≥ 0 then the project is feasible

 The project with the highest positive NPV is preferred

 If IRR ≥ r (with r = ke, wacc) then the project is feasible

 The project with the highest IRR is preferred
NPV and discount rate
Project A
Discount rate
10.000%

As far as architectural
Year Net cash flow Discount factor Discounted cash flow
 1 ‐15,000 0.9091 ‐13,636

projects are
2 4,000 0.8264 3,306
3 4,000 0.7513 3,005
4 4,000 0.6830 2,732
concerned, there is 5 4,000 0.6209 2,484
6 4,000 0.5645 2,258
usually an inverse Npv 148
Irr 10.4%
relationship r NPV
1% 4,370
between NPV and 2% 3,778
3% 3,222
discount rate 4% 2,699
5% 2,208

 The higher the 6%

7%
1,745
1,309
discount rate is, the 8%
9%
899
512
lower the NPV is 10% 148
11% ‐195

 The lower the 12%

13%
‐519
‐824
discount rate is, the 14%
15%
‐1,112
‐1,384
higher the NPV is 16% ‐1,640
17% ‐1,883
18% ‐2,111
19% ‐2,327
20% ‐2,531
NPV and discount rate
NPV, discount rate, and IRR
Project A Project B
Discount rate Discount rate
10.000% 10.000%
Year Net cash flow Discount factor Discounted cash flow Year Net cash flow Discount factor Discounted cash flow
1 ‐15,000 0.9091 ‐13,636 1 ‐1,250 0.9091 ‐1,136
2 4,000 0.8264 3,306 2 400 0.8264 331
3 4,000 0.7513 3,005 3 400 0.7513 301
4 4,000 0.6830 2,732 4 400 0.6830 273
5 4,000 0.6209 2,484 5 400 0.6209 248
6 4,000 0.5645 2,258 6 400 0.5645 226
Npv 148 Npv 242
Irr 10.4% Irr 18.0%
r NPV r NPV
1% 4,370 1% 685
2% 3,778 2% 623
3% 3,222 3% 565
4% 2,699 4% 510
5% 2,208 5% 459
6% 1,745 6% 410
7% 1,309 7% 365
8% 899 8% 321
9% 512 9% 281
10% 148 10% 242
11% ‐195 11% 206
12% ‐519 12% 171
13% ‐824 13% 139
14% ‐1,112 14% 108
15% ‐1,384 15% 79
16% ‐1,640 16% 51
17% ‐1,883 17% 25
18% ‐2,111 18% 1
19% ‐2,327 19% ‐23
20% ‐2,531 20% ‐45
NPV, discount rate, and IRR
References

 Wyatt, P. (2013), Property Valuation, 2nd ed. Oxford: Wiley

Blackwell.

 Isaac, D. (2002), Property Valuation Principles,

Basingstoke: Palgrave Macmillan.
Suggested readings

 Copiello S. (2015), Achieving affordable housing through

energy efficiency strategy, Energy Policy 85, 288-298. Doi:
10.1016/j.enpol.2015.06.017

 Copiello S. (2016), A Discounted Cash Flow variant to

detect the optimal amount of additional burdens in Public-
Private Partnership transactions, MethodsX 3, 195-204. Doi:
10.1016/j.mex.2016.03.003

 Lilford E., Maybee B., Packey D. (2018), Cost of capital and

discount rates in cash flow valuations for resources
projects, Resources Policy 59, 525-531. Doi:
10.1016/j.resourpol.2018.09.008