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Uncertainty Is Causing Real Estate Teams to Rely on Discounted Cash Flow More Than Ever

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Tenants refusing to pay rent, employees avoiding the office, and a recession roiling the economy has created an uncertainty that’s permeating through the commercial real estate industry. The pandemic has both created highly fluctuating conditions and slowed the amount of new deals to a near standstill. The lack of clarity into the future and the absence of comparable transactions has made valuing a building harder than ever. So, to help make sense of this uncharted territory real estate teams are looking to a tried and true method of valuation: discounted cash flow

“Discounted cash flow valuation is needed now more than ever,” Troy Sivak, director at Altus Group said. Sivak works in the valuation advisory arm, one of the leading valuation management providers in the US supporting more than 100 of the world’s biggest funds. He has years of hands-on experience helping real estate companies model their assets’ valuations. “When it comes to understanding a property’s potential, DCF is king. It reflects everything going on at a property. Other methods to calculate value simply don’t take as much into consideration. Plus, it creates an audit trail so everyone on a team can go in and look at all of the assumptions that lead to the value.” Discounted cash flow is a method of valuation that estimates the net present value of a building based on all of the future revenues and expenses.

As the pandemic suddenly shut down large parts of the world’s economy, investors and landlords found themselves in a fog of war, not knowing what was going to happen but knowing they had to assign some level of risk. Cap rates and sales comparisons have long been an industry standard, good for measuring value at a specific point in time. Modeling real rent collection is a common process, adjusting for near term deferment or loss. DCF combines all of those elements, looking at every detail throughout the entire hold period of an asset. Instead of a snapshot of an assets’ current value, DCF looks at every frame to create a moving picture. 

With so many moving parts in our tumultuous economic situation, a moving picture of commercial value focused on the long-term while factoring in short-term concerns provides much needed perspective. Instead of getting lost in the trees, DCF allows you to see the forest. 

“Discounted cash flow valuation for investment-grade properties is paramount, it reflects everything going on. Other approaches can’t capture all the intricacies of a discounted cash flow,“ said Sivak. “With discounted cash flow, you can really dive in and show what’s happening beyond year one. Since COVID, it’s gotten even more crucial.”

DCF is more critical now than ever because of how granular the process can get. For it to be accurate, many new considerations are being added to the equation. In Houston for example, where major industries like airlines and oil and gas have been hit particularly hard, DCF valuations of office buildings are being adjusted on a tenant by tenant basis. By looking for businesses exposed to those lagging industries and assigning different levels of confidence in the tenant’s cash flow to the portfolio, these idiosyncrasies can be accounted for. With other forms of valuation, you’d adjust the discount rate to account for the possibility of missed rent payments. DCF can maintain a similar discount rate, adjusting other things to model the drop in confidence. As they say, the devil is in the details. More details with a clear audit trail means with a DCF valuation approach, you’re more likely to find and account for whatever devils may arise. 

The only disadvantage to discounted cash flow valuation is the process is only as good as the assumptions of the analyst. That means it’s important to carefully consider each of the components of the discounted cash flow equation. Dealing with the economic fallout wrought by the coronavirus pandemic isn’t the first time the industry has had to fall back on this methodology. During the 2008 financial crisis, commercial real estate valuations were fluctuating even more than they are now as mortgage backed securities markets reeled from toxic assets. Then, as now, property companies are re-evaluating their models several times each quarter to keep up with the chaos. 

“There is a big disparity between what we are seeing now in the economy and what we might see in five to ten years, once we have a vaccine and this is all behind us so you have to factor in both long and short term possibilities,” said Daniel Kudrik, another director from Altus Group’s valuation advisory team. Some teams model cashflows as far as ten years out. According to Kudrik, the power of a long term approach to value is that it can smooth out some of the temporary shortfalls, like the lost rent collection that many are experiencing today.

Another looming consideration for many teams is inflation. While it is low now due to the recessionary effects of the slowdown, some are worried that it might affect building values if it increases rapidly due to all of the newly printed money being used to shore up the economy of many countries. “Teams should be adjusting models to look at certain metrics like inflation or rent rates as variables and see how it would change their models if they accelerate over time,” Kudrik said. “This type of nuanced modeling can be achieved with software but many teams are just used to pegging variables and applying them over the entire cashflow’s projection, I think that will likely change.”

Discounted cash flow offers immense value to owners because of its value to investors. The process strips away all the subjectivity and ‘artistic’ nature of commercial real estate valuation. Every assumption is clear and accounted for, like leaving breadcrumbs for investors to follow you to a conclusion. The comprehensive nature of discounted cash flow valuation has made it not only perfect for our current situation but a new industry standard. Valuing your asset with discounted cash flow reduces risk from unknowns by providing a better idea of the investment value of a property throughout its entire life. In an economic climate with unpredictability around every corner, being able to see a worst case, base case and best case scenario can help stakeholders make more intelligent business decisions.

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