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Journal of Property Investment & FinanceThe discounted cash
flow model for property valuations: quarterly cash flowsNick
French
Article information:To cite this document:Nick French,
(2013),"The discounted cash flow model for property valuations:
quarterly cash flows", Journalof Property Investment & Finance,
Vol. 31 Iss 2 pp. 208 - 212Permanent link to this
document:http://dx.doi.org/10.1108/14635781311302618
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PropertyInvestment & Finance, Vol. 30 Iss 3 pp. -Nick French,
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EDUCATION BRIEFING
The discounted cash flow modelfor property valuations:quarterly
cash flows
Nick FrenchDepartment 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 theincome approach, the investment
method looks at the pricing of assets that produce income over
aninvestment holding period. The discounted cash flow (DCF)
technique or model can be developed tolook at the cash flows on a
quarterly basis to reflect the actual receipt of the cash flows.
The aim of thispaper is to give an overview of the DCF quarterly
model.
Design/methodology/approach This education briefing is an
overview of the DCF quarterlymodel.
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 tomodel the cash flows
appropriately.
Originality/value This is a review of existing models.
Keywords Market value, Quarterly cash flows, Discounted cash
flow, Real estate, Cash flow
Paper type General review
IntroductionIn an earlier Education Briefing (French, 2012), it
was shown that an explicitdiscounted cash flow (DCF) valuation
involves projecting estimated cash flows overan assumed holding
period, plus an exit value at the end of that period, usually
arrivedat on a conventional all-risk yield (ARY) basis (exit
yield). The cash flow is thendiscounted back to the present day at
a discount rate that reflects the perceived level ofrisk. This
method does the same as any valuation method, it is the process
ofdetermining market value. An estimation of the price of exchange
in the market place.
Valuation example annual in arrearsIn 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
commercialproperty market has traditionally used annual (nominal)
market benchmarks suchas the ARY based on the assumption that rents
are received annually in arrears.Indeed, The Mallinson Report
(RICS, 1994, 2011) commented on this particular pointstating:
[. . .] are we wise to continue using tables which assume rent
to be received annually in arrearswhen 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 &FinanceVol. 31 No. 2,
2013pp. 208-212q Emerald Group Publishing Limited1463-578XDOI
10.1108/14635781311302618
JPIF31,2
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But, the point is that it does not matter when undertaking
implicit valuations. Implicitmodels, 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 isexpressed as an annual in arrears rate, it is
implying/reflecting the reality that rents arereceived quarterly in
advance. In simple terms, the ARY is slightly lower than it wouldbe
otherwise so that the multiplier (1/ARY) is slightly higher and the
priceestimation/value corresponding higher to reflect the advantage
of a quarterly inadvance cash flow. Thus, using the same example as
in the previous EducationBriefing (French, 2012), the cash flow
(Example 1) was presented as an annually inarrears cash flow to be
valued implicitly (Example 1A) and explicitly[3] (Example 1B).The
following example was used and, as can be seen, both valuation
techniquesproduce the same capital value of 12.5 m before costs.
This is the estimate of pricethat investors would pay for this
investment knowing that the rents are actuallyreceived 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 plus4 per cent market risk plus 2 per cent
property/covenant risk).
Rent reviews five 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 flows down the page)This model uses
annual in arrears assumptions and assumes a sale at end of lease at
anexit yield equivalent to todays ARY (Table I).
Valuation example quarterly in arrearsBefore looking at
quarterly in advance (Q in A) DCF valuations, we will look
atmodifying the cash flow into quarterly periods but still in
arrears. The reason forthis extra step in the transition to Q in A
is to discuss the ARY as an annual andquarterly rate.
There is an issue in the valuation and the conversion of the
annual in arrearsbenchmark 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 isalso divided by 4 and the valuation self
adjusts as the YP multiplier (obviously, beingthe reciprocal of the
ARY) increases by the same magnitude. The valuation become
asillustrated in Example 2.
Educationbriefing
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 five 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 reflect quarterly
in advance receipts tooand that will be considered in the next
Education Briefing in this series.
That said, there is a strong argument that adjusting implicit
models is superfluous.The implicit model is a short cut and, as
such, it should give an estimate of prices in itssimplest form. To
use the analogy of taking a short cut across the field, the
impliedannual in arrears model (Example 1A) is a straight line
between points X and Y. Anyadjustment to the model (even is
mathematically correct) means that you are nowwalking from X to Y
in a zig-zag. This seems to be a superfluous.
B. Explicit DCF (annual cash flows down the page)This model uses
quarterly in arrears assumptions and assumes a sale at endof lease
at an exit yield equivalent to todays ARY (inflated valuation of
above)(Table II).
As can be seen, this is still a good estimate of price but by
using the simple annualtarget rate divided by 4 produces (10.75 per
cent/4 2.6875 per cent) slightly lowervaluation. 12.394 m rather
than 12.5 m.
Year Rent () Capital () Cash flow () PV @ 10.75 per cent PV
()
1 1,000,000 1,000,000 0.903 902,9352 1,000,000 1,000,000 0.815
815,2913 1,000,000 1,000,000 0.736 736,1544 1,000,000 1,000,000
0.665 664,6995 1,000,000 1,000,000 0.600 600,1806 1,170,415
1,170,415 0.542 634,2757 1,170,415 1,170,415 0.489 572,7098
1,170,415 1,170,415 0.442 517,1189 1,170,415 1,170,415 0.399
466,924
10 1,170,415 17,123,390a 18,293,805 0.360 6,589,716Market value
12,500,000
Notes: aThe sale price at exit is the projected rent for year 11
(1,369,871) YPed at the exit yield of8 per cent; this is 1,369,871
12.5 17,123,390Table I.
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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 slightlyhigher answer of 12.75
m.
Both are approximations that come about because comparables for
the ARY (k) andtarget rate (e) are analysed on an annual basis and
then adjusted (crudely) intoquarterly figures.
A more robust approach can be adopted when looking at Q in A
valuations and thiswill be illustrated and explained in the next
Education Briefing in this series.
Quarters Rent () Capital () PV @ 2.6875 per cent PV ()
1 250,000 0.9738 243,4572 250,000 0.9483 237,0853 250,000 0.9235
230,8814 250,000 0.8994 224,8385 250,000 0.8758 218,9546 250,000
0.8529 213,2237 250,000 0.8306 207,6438 250,000 0.8088 202,2089
250,000 0.7877 196,916
10 250,000 0.7671 191,76311 250,000 0.7470 186,74412 250,000
0.7274 181,85713 250,000 0.7084 177,09714 250,000 0.6898 172,46215
250,000 0.6718 167,94916 250,000 0.6542 163,55317 250,000 0.6371
159,27318 250,000 0.6204 155,10419 250,000 0.6042 151,04520 250,000
0.5884 147,09221 292,604 0.5730 167,65322 292,604 0.5580 163,26523
292,604 0.5434 158,99224 292,604 0.5291 154,83125 292,604 0.5153
150,77926 292,604 0.5018 146,83327 292,604 0.4887 142,99028 292,604
0.4759 139,24829 292,604 0.4634 135,60330 292,604 0.4513 132,05431
292,604 0.4395 128,59832 292,604 0.4280 125,23333 292,604 0.4168
121,95534 292,604 0.4059 118,76335 292,604 0.3953 115,65536 292,604
0.3849 112,62837 292,604 0.3748 109,68038 292,604 0.3650 106,81039
292,604 0.3555 104,01540 292,604 17,123,390 0.3462 6,028,996
Market value 12,393,724
Table II.Quarterly full
DCF explicit
Educationbriefing
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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 flow blockedin periods equivalent to the rent
review period, (2) an annual cash flow vertical (down thepage)
layout and (3) an annual cash flow horizontal (across the page)
layout.
References
French, N. (2012), The discounted cash flow 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 CharteredSurveyors, 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 inquarterly in advance cash flows, Journal
of Property Investment & Finance, Vol. 18 No. 2,pp. 235-8.
Corresponding authorNick French can be contacted at:
[email protected]
JPIF31,2
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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 cashflows. 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 cashflows. Journal of
Property Investment & Finance 31:6, 610-614. [CrossRef]
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