Capitalisation or the DCF approach?

The review presents cogent arguments to support its decision. The main one appears to be that DCF is the standard method for valuing businesses and real estate investment is a business. It’s true that in some countries landlords let on short leases and remain responsible for all costs, which is not the case in the UK where we have FRI leases. In those circumstances, landlords need to be as hands-on as any business. But could a building let on an FRI lease where the landlord seldom needs to even see the property truly be called a business?

Another rationale is that since DCF is used for analysis and the market is taking a more analytical approach, DCF should lead. That argument seems weak to me as the use of capitalisation does nothing to prevent DCF analysis, especially as modern valuation software has long been able to simultaneously do both.

What’s missing for me is the use of reference to open-market-comparable transactions, which have always been fundamental to real estate valuation. It’s possible to reverse-calculate prices achieved in the market to ascertain the equivalent yield used by buyers and sellers. The same cannot be said of the DCF approach since there are infinite combinations of discount and anticipated growth rates that will combine to give the same purchase price.

The RICS review does go on to say that “in circumstances where a traditional income capitalisation approach is the most suitable method, the valuer should justify this in their analysis and reporting”, but omits to indicate what criteria might qualify as suitable.

When I long ago qualified as a valuer I was taught that DCF calculates worth rather than value. ‘Value’ was what the property could sell for on the open market and ‘worth’ was specific to the owner or potential owner. So while value is an assessment of market conditions, worth can have unconnected criteria.

There’s another valuation factor that would be difficult to accommodate using DCF. Where market conditions have changed and a property is let at a rent well above or below market value, there will be a significant change in risk. Capitalisation addresses that by a change in the capitalisation rate. While DCF can accommodate that by shortening the analysis period, it then has to revert to capitalisation to calculate the exit value.

It will be interesting to see how the valuation profession reacts to the review.

Michael Gilbert, chartered surveyor, KEL