Interview: The Growing Importance of Discounted Cash Flow

Written By: Bruce A. Kellogg, MAI, FRICS

The following is an interview with a good friend and a well-respected real estate professional, specializing in valuation, who has contributed significantly to the industry, both as a practitioner and an educator for several decades. Currently involved in consulting, Jim Vernor, Ph.D., MAI was a full-time professor at Georgia State University in Atlanta, GA and is currently Chairman Emeritus and Associate Professor Emeritus of Real Estate at GSU.

To add to his honors, he was awarded the William Kinnard Award in 2001, the Committee Service award in 2003 and the James H. Pritchett Award in 2004 by the Appraisal Institute. He received the Outstanding Faculty Award by the GSU Real Estate Alumni Group and the 2008 Legion of Leaders Award from the Atlanta Area Chapter of the Appraisal Institute. Jim served as Chairman of the GSU Real Estate Department from 1984 to 1989, where his teaching responsibilities included real estate appraisal, finance, investments and market research. Jim is currently teaching and served on the development team for an Appraisal Institute seminar on Discounted Cash Flow.

In total, Jim brings great knowledge and experience to this forum to discuss a subject near and dear to our hearts: the usage and importance of the Discounted Cash Flow in the analysis of real estate. The following are the questions posed to Dr. Vernor:

Question: Why is it that the discounted cash flow (DCF) has become the primary methodology for appraising income-producing property?

Answer: All of our valuation approaches are models; each is a simplification of the important parts of a more complex reality. DCF works when it captures thinking by investors. These are frequently more sophisticated investors who make forecasts of the cash flows they think are most likely to occur in the future. Such investors include pension funds and pension fund advisors, investment bankers, insurance companies and real estate investment trusts.

Question: Why is it more accepted than the direct capitalization process?

 

Answer: Smaller and less sophisticated investors are more likely to rely on a direct capitalization approach which considers only the ratio of the first year net operating income to sales price. In this case, the future growth pattern in incomes and the change in the value of the asset over a holding period are all implicit in the cap rate instead of explicit as in DCF. On the other hand, some investors may not use an income approach at all, preferring a sales comparison or cost type analysis, especially for simpler properties or owner occupied properties.

Question: During this time of market uncertainty, why is the DCF considered a more accurate (or preferably, reliable) way to analyze an income-producing property than the direct capitalization process or the other approaches to value?

Answer: The reliability of a model can be judged in terms of how well it reflects actual investor thinking in a market. Particularly now, the near term performance of many assets is discouraging, but buying and selling activity continues because some investors have confidence in a return to performance at some deferred date, and DCF models that. Once an analyst has developed a forecast of the magnitude and timing of a future market movement, a DCF model helps to quantify what cash flows will occur year to year and to apply a risk-appropriate discount rate to convert those cash flow forecasts into a value opinion. The model works when this is how actual decision-makers think.

Question: What is the reason why the ARGUS Software product(s) became the standard models for financial analysis in the real estate industry, especially relating to the valuation of properties?

Answer: I don’t know if or why one product beat out the competition, but Argus does seem to me to have become the standard alternative to a spreadsheet program like Excel or Lotus.

Question: What are the advantages over the Excel spreadsheet, understanding that there is a place for them based on certain requirements? Answer: Excel is a good learning tool for beginners and for some very simple properties such as those in stable operations without complicated lease structures or financing; it may be more economical for an analyst with only rare needs for DCF. The place of Argus as I see it is for complex, multi-leased properties with escalations, pass-throughs, and varying renewal probabilities. It can model financing, development projects and subdivisions. Analysts who have become expert in Excel can sometimes model these situations without errors, but clients have confidence in proprietary cash flow software that has been error tested and used by many analysts.

Many thanks to Dr. Vernor for his thoughts on DCF and its importance to the real estate community. We appreciate his insight and years of service to the profession. May good fortune and low cap rates be in our future!


Photo taken of Bruce the Blogger and Dr. Jim Vernor in September 2005 in Westbury, NY at the L.I. Chapter Installation Dinner.

Comments

[Nelson Stewart, MAI, SRA]

It seems to me that a DCF model is only as good as the accuracy of its forecast. Even the thinking of investors is not necessarily very accurate. If you are going to employ a DCF model, projecting beyond a 5 year period appears to be an exercise in futility. If there is a bigger picture that I am not aware of, please explain it to me.

[Daniil]

DCF has always been an important valuation method but the reality of the situation is a lot of investors, especially at the smaller deal-size level are hesitant to use pro-formas and forward-looking assumptions. We, as well as most investors we work with, are much more comfortable capitalizing the current NOI rather than relying on projections.