Guidance on DCF for valuation of investment property updated

RICS' publication of new global practice information on using explicit discounted cash flow (DCF) valuations for investment property has come about for three key reasons. 

First, the previous guidance in this area was published 13 years ago and needed updating in line with technical advances made in that time. Second, it had to be expanded from UK to global coverage. 

Third, it is part of the response to the major review of valuation carried out last year by Peter Pereira Gray, which included three recommendations relevant to valuation methods. 

One of these recommended that the valuation profession should incorporate the use of DCF as the principal model applied in preparing property investment valuations. 

This recommendation has received considerable scrutiny, and was in some instances misconstrued as taking away the choice that a valuer can exercise in applying the method they think is most appropriate. 

The valuation review, while endorsing DCF, acknowledged as much, and also noted that direct comparison or a market approach using capitalisation rates directly sourced from the analysis of comparable sales, may be entirely appropriate in many circumstances. 

The practice information endorses this position and discusses different situations where either cash flow or capitalisation rate comparison methods might be adopted as the appropriate model to use. It also suggests that it may be entirely appropriate in some cases to adopt both or any other combination of methods and models. 

But the new practice information also points out that a capitalisation rate is often called an all-risks yield, because it hides most of the underlying assumptions that determine the value of the asset. All valuations carried out by reference to a capitalisation rate can also be unpicked to illustrate various combinations of cash flow potential and comparison with wider investment markets. 

This means that investment valuations carried out with reference to a capitalisation rate can also be put into a simple cash flow context. It is my view that the valuation review envisages that happening over time in jurisdictions where the capitalisation rate model is used. The practice information provides details of how this could be achieved.

The practice information reminds valuers that justification is required in all situations, whether using the DCF method or not. In that sense, this alleviates one of the major concerns about Pereira Gray's recommendations, which seemed to require justification of method in some circumstances but not others.

The practice information discusses various characterisations of the choice of methods. For example, where there is good information on transactions and other evidence of capitalisation rates, and the valuer is asked to determine the most likely exchange price at that moment – namely the market value – the comparable method using the capitalisation rate can be the most appropriate approach. This would provide the justification for the method. 

If simple cash flow outputs were analysed from the capitalisation rate valuation and reported using the guidance in the practice information, this would give clients more information about the implications of current market price levels.

In turn, this would not only protect valuers' rights under Red Book Global Standards to decide the correct method, but also address and implement the review's concern that we need to be more explicit in the assumptions behind prices. 

The bottom line is that all capitalisation rate-based implicit comparative valuations can be placed in a cash flow framework. If there are still valuers and clients who do not know this, then the continuing professional development and training provision that accompanies the practice information will be particularly important.

A number of responses to the consultation wanted actual figures, such as discount rate ranges. However, the practice information is written on the basis of guiding rather than prescribing: valuation isn't a set of prescriptions. All guidance can do is discuss issues and offer options rather than presenting definitive outcomes, especially numerical ones.

The practice information is not part of Red Book Global Standards and is not mandatory. It is written with the intention to guide, especially in those jurisdictions where an explicit DCF is not the current or likely future principal model or is only used for the investment value – or worth – basis.

Where an explicit DCF is the normal model for market valuations, the practice information should be used to complement and not compete with existing practice.