'It's about trust': why DCF is the future of valuations

Author: Peter Rose

A different method will bring a much-needed quantitative emphasis to valuations.

 

It is a truism of real estate that the market is underpinned by valuations. Without the grease provided by accurate and widely-accepted valuations, the wheels of investment very quickly grind to a halt.

But as vital as they are, valuations are not an absolute, immutable fact. They are open to interpretation, tested by different assumptions and often reliant on individuals’ biases. By their nature, they tend to be a snapshot of values at a given point, rather than forward-looking assessments that fully consider changes on the horizon.

The shortcomings of long-held valuation methods haven’t offset the benefits of these metrics up until now. With shifts in commercial real estate measured in decades rather than years, investors and lenders could afford to take a traditional, often historic facing approach. But that is no longer the case.

 

This is not simply a quest for greater accuracy – it is about enabling transactions by providing valuations that people can trust

 

The structural changes taking place across retail property, and the pandemic-led acceleration of trends in logistics and office requirements, demonstrate the need for valuations that truly reflect an asset’s current status and particularly its future prospects. This is not simply a quest for greater accuracy, it is about enabling transactions by providing valuations that buyers, sellers, lenders and shareholders can trust.

Which brings us to the discounted cash flow (DCF) method. There has been growing talk of DCF within the valuation community, and we can expect it to feature prominently in the review currently being undertaken by Peter Pereira Gray on behalf of the RICS. But adoption has been slow, with some commentators raising an eyebrow at vested interests in the valuation community.

A more forward-looking assessment

The arguments in favour of DCF are fairly straightforward. Analysing income streams through this method leads to a more quantitative, forward-looking assessment, giving less prominence to the opinions of valuers and providing more granular detail.

Moreover, it provides a sounder base for valuation in markets where deal levels are low and evidence from comparable transactions is thin on the ground. And even where such evidence exists, these benchmarks are often changing so quickly as to make comparisons obsolete; this doesn’t only apply in falling markets such as retail, but rising ones like logistics too. Accuracy is vital both on the downside and the upside.

There are also advantages in bringing commercial real estate into line with other asset types. In the search for yield and balanced portfolios, many investors are not simply looking at different property sectors, but allocating capital to a range of classes, including equities and bonds. Financial assets such as these have long been valued using DCF, and assessing real estate on the same basis has the potential to attract greater capital to the sector as investors embrace a methodology they are comfortable with.

 

There is a perception that DCF is more labour-intensive, but much of this has been mitigated by tech and smart tooling

 

Given these benefits, it is worth asking why DCF hasn’t been as widely adopted in the UK as it has in other jurisdictions. As one of the most mature markets, the UK has traditionally had a stable valuation environment that has perhaps reduced the need for innovation, but as we have seen that is no longer the case. There is also a perception that DCF is more labour intensive than other methodologies, but much of this has been mitigated – and will be reduced further – by tech and smart tooling.

The valuation community’s concerns about being sidelined are understandable, but that is a misreading of the situation. DCF analysis still requires expert capabilities to be at its most effective, something that is especially true in a UK market where most assets have bespoke quirks that resist like-for-like comparisons. Adding DCF to the mix of methodologies doesn’t in itself weaken traditional approaches, but instead brings another perspective that strengthens confidence in the value of each asset. In short, the more datapoints, the better.

At their heart, valuations are about trust, and evidence is mounting that a growing number of stakeholders in the property community no longer trust the older methodologies. Many listed propcos trade at a discount of up to 20% to their stated net asset value, highlighting the market’s circumspect view of their accuracy.

Traditional valuation methodologies form the backbone of our Datum software platform, and these are augmented by detailed cashflow projections used in a DCF valuation. As the commercial real estate market evolves, it is clear that widespread adoption of DCF, in conjunction with traditional approaches, is the only way valuations can continue to fulfil their vital role of greasing the wheels. The landscape is changing, and real estate needs to adjust and adapt.

 

ABOUT FORBURY

Over the years, more features and functionality have progressively been added into Forbury's software. We are continuously thinking of better ways to leverage our property valuation tech for the benefit of our customers. Property professionals using Forbury gain increased accuracy and speed, empowering them to cover more of the market without additional resources and expense.

 

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About the Author: Pete Rose is Forbury's Chief Revenue Officer, and his ideas are inspired by his passion for the commercial real estate industry.

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