PROPERTY JOURNAL

Guidance on DCF for valuation of investment property updated

RICS has published new practice information on using the discounted cash flow method in valuation to address concerns raised in a recent review of this area

Author:

  • Professor Neil Crosby MRICS

10 November 2023

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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. 

Document clarifies Red Book's treatment of methods

Detailed coverage of methods is conspicuously absent from RICS Valuation – Global Standards (Red Book Global Standards). This is because it is a process manual that specifically leaves the choice of method to the valuer. There is therefore no such thing as a Red Book 'method'.

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.

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Justification required whatever method applied

Pereira Gray's review suggested that where the cash flow method is not used then the valuer must justify their approach. But Red Book Global Standards require more than that. 

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.

Guidance aims to support not prescribe

The practice information goes further than previous guidance on DCF in that it has separate chapters on market value and investment value. The valuation question being answered has a significant impact on the application of the DCF method, and on the way the inputs are sourced and applied. The guidance therefore gives information on these different inputs, but is not prescriptive about them. 

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.

 

Professor Neil Crosby MRICS is professor emeritus, University of Reading, and lead author for the new RICS practice information on DCF valuations

Contact Neil: Email

Related competencies include: Valuation, Valuation of businesses and intangible assets

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