The findings and recommendations of the RICS Review of Real Estate Investment Valuations, chaired by Peter Pereira Gray, were published in January.
The report had been commissioned by the RICS Standards and Regulation Board (SRB) in 2021. The brief was to recommend a framework that would ensure confidence in property valuations in today's markets. This would apply in particular to valuations on which third parties rely.
The SRB has accepted all 13 recommendations from the review, including the two-part recommendation 8, and RICS is currently working to implement these. All the recommendations were pertinent and considered, but the first part of recommendation 8 is of the greatest interest here as it relates directly to the use of the appropriate valuation methods and model for investment valuations.
Recommendation 8(i) says: 'The valuation profession should incorporate the use of discounted cash flow as the principal model applied in preparing property investment valuations.'
Forgive my pedantry – I was an academic for 38 years – but the review has here fallen into the trap of using 'discounted cash flow' (DCF) to refer specifically to explicit discounted cash flow models. While the profession often uses the term this way, it is wrong to do so.
All investment valuations are based on the present value of a projected cash flow, which means that all such valuations are, in fact, DCF, regardless of the model used. The actual distinction between valuation models is whether they are an implicit capitalisation model or an explicit DCF model.
Implicit models reflect any expectation in the growth of market rents or capital value in the yield. Explicit models on the other hand allow for any growth expectation in the cash flow and discount this at a required rate of return, which is usually higher. The role of the valuer is, and always has been, to use the most appropriate model to estimate market value; that is, the expected price in the market.
There is an old adage that one should value as one analyses, and this can be applied perfectly here. If a market analyses the attractiveness of an investment by simple heuristics such as the initial yield and market rent, then the appropriate valuation approach will be an implicit capitalisation model. The market value will be derived by multiplying the market rent and, in some cases – according to term and reversion or layer – by the rent passing by the reciprocal of the capitalisation rate or yield. These two factors, the rent and the yield will be derived from an analysis of the market. In the UK, we refer to the capitalisation rate used as the all-risk yield (ARY), or equivalent yield if used for a reversionary property.
However, if you value in a market where the main players analyse the property by explicitly projecting forward the likely rents over time – say ten years – and allowing for specific expenditures, before discounting all net rentals back to a present value using an overall required rate of return, then the appropriate valuation model may reflect this. Valuers will thus use the explicit DCF model.
In such markets, the appropriate model will become the principal model. Recommendation 8(i) is therefore only affirming the natural movement towards using more explicit valuation models, and will simply accelerate this transition.
RICS members' responses to the review have on the whole been positive. However, some articles and social media comments have picked up on the apparent implication that investment valuations should exclusively use explicit DCF models, and move away from implicit ARY models.
In explaining what the review suggests about the use of explicit DCF models, it says there is no call for a particular valuation model to be prescribed. Rather, the review says different methods and models may be used, and it supports the use of cross-checking the results of one with the use of another where both models are used and the market values reconciled.
The review also highlights that clients are less and less likely to accept implicit valuation inputs, assumptions and outcomes. Instead, the models should be explicit, to achieve the required levels of transparency, understanding and education.
The review also noted that DCF could better consider operational factors and the impact of time. The call for evidence for the review also saw substantial support for wider use of DCF.
There will thus be no prescription for using explicit DCF modelling alone. The appropriate valuation model or models should be used for the task in hand. Implicit models shouldn't be abandoned in the desire to make everything explicit; the capitalisation model still has the advantage of being based on market evidence.
In other words, the use of the implicit ARY models will continue where appropriate. Maybe it will be a way of double checking an explicit DCF model, or maybe it will be the principal valuation model, depending on the asset type. If you are valuing a single unit high street shop then, unless it is on a turnover rent, there is no need to use an explicit DCF model. The point of the review is to highlight that many asset types that investors buy – such as shopping centres, student accommodation or multi-occupancy offices – where there are multiple tenants and cash flows, then these are the assets that will be analysed by explicit DCF models. The principal valuation model for such assets should therefore also be an explicit DCF model.
Some valuers explicitly state the cash flows over a five- to ten-year period but still keep rental figures in today's terms. This is not an explicit DCF model in the normal sense. Instead, it is an elaborate implicit term-and-reversion model. Care should be taken not to refer to these as DCF models. If they only use the ARY or equivalent yield as the discount rate, they are still implicit models, identifying any growth expectation as part of the yield rather than in the cash flow.
All valuations rely on comparison. In the case of implicit investment valuations, this normally involves the analysis of comparables to determine net initial yields and the market rent. One of the advantages of implicit models is that they price to market with reference to only those two variables.
The greater use of explicit DCF models will require that the valuer looks at, and has access to, other comparable evidence. This may include discount rates used in the investors' analyses, the information that underpins the increased use of turnover-based rents, or a better insight into how clients price risk.
Valuers can only provide valuations on an explicit basis if this data is available to them. This may be from aggregated third-party data, or valuation teams may have sufficient confidential information direct from the principal investors in the market.
Using explicit DCF will require clients to share details of their current required rate of returns – target rates – with the valuation profession as a whole. At the moment, this happens on an ad hoc basis, and it could be that the predominance of implicit models in some markets has endured this long because more explicit information has not been shared particularly information on the target rates that investors in the market are seeking.
Internal rate of return information is readily available in real time in the stock market, but this tends not to be the case in the property market. MSCI, previously IPD, provides data on historic performance measurement which can help to anchor estimates of target rates, but what is really needed is regular surveys of investors' target rates by property type in real time as this would greatly support the transition to explicit DCF models, as the review recommends.
But the main advantage of moving towards explicit modelling is that information and assumptions are revealed and justified to a much greater extent than when using implicit models. While implicit models recognise the previous market pricing of similar assets, explicit models disclose the market expectations used in the valuation.
In working to implement all the recommendations, RICS is making changes to the Valuation Global Standards – the Red Book – and the UK national supplement.
However, I expect that recommendation 8(i) will be dealt with mainly by a revision to the current edition of Discounted cash flow for commercial property investments, RICS guidance note. This will rely on advice and comments from and consultation with all the principal stakeholders, including valuers.
More broadly, any move toward the greater use of explicit DCF models will be for investment properties, where investors look at the asset as a cash flow. Other assets that investors buy and sell on initial and reversionary yields will still be valued using the ARY. The baby will not be thrown out with the bathwater.
In essence, the review will ensure that investment valuations are provided to clients with increased transparency. That can only lead to the greater confidence in property valuations that everyone wants.
Related competencies include: Valuation
Dr Paul Beckett 22 May 2023
Fiona Mannix 18 May 2023
David Marshall 12 May 2023