COMMENT In a significant moment in the valuation profession, Peter Pereira-Gray’s Independent review of real estate investment valuations called for a much more analytical business and one that uses discounted cash flow as the principal approach to valuation.
The UK market has used the growth implicit traditional approach as the ‘go-to’ method for years, so this is a change for the real estate industry, the valuation profession, our clients and those who rely on our valuations – as well as our regulator, the RICS, which now has to get the valuation profession to modernise.
Mirroring the market
There has been a lot of debate about DCF, as most valuations of income-producing assets are based on a future cash flow.
Valuers are thinking about how best to carry out DCFs and where to get the required data from. A DCF differs from the traditional approach in that it adopts the market’s assessment of future growth in an explicit way. That future income stream is then discounted back at a discount rate to derive market value.
The traditional approach differs in that it only uses today’s rental values and discounts the income at a rate based on analysis of comparable transactions.
Gone will be the expression that “it is all in the yield”. At the heart of the case for using a DCF is that it will make valuers mirror how market participants price assets. It will not necessarily apply to a shop let to a single tenant which would typically be sold in an auction but it is well suited to the valuation of most income producing investment grade real estate assets. In addition, it will give us a more transparent and explicit way of showing income and cost trends.
Valuation language is changing – we are talking about internal rates of return and hurdle rates, rental growth and explicit costs. We are thinking about growth which is very relevant in the current inflationary economy. We are analysing our transactional evidence through DCF models to obtain market observed discount rates – using the valuers’ adage of “revaluing how we devalue”.
Right call
As well as considering rental growth prospects, DCF also requires us to think explicitly about the impact of obsolescence and aging buildings. And as the market looks at the cost and benefit of moving real estate forward on its path to net-zero carbon, DCF is really the only tool that can quantify economic impact.
With that comes the huge opportunity for gathering data for green initiatives as it emerges. Hopefully, by sharing this data it will help our clients make better and faster decisions about their real estate.
The switch will not be an immediate fix – the valuation profession must be confident that DCF produces an accurate market value. I suspect there will be a lot of dual reporting and a transition period.
There is a risk that confusion will arise between market value and investment value. DCF is great at assessing both, but they are very different – and confidence will only come if clients and valuers understand that difference.
There is a risk that some valuers will just use the growth-implicit traditional approach and then run a DCF and back-solve the discount rate to get to the same answer. That would be against the spirit of the review and would undermine confidence.
Valuers need to analyse transactions in a growth explicit model to see what discount rates are – but also to make sure that they are even closer to the runners and riders in any market to see how they price assets, what their hurdle rates are and how they model growth.
With all this information, reported in an analytical way to clients, I think the valuation profession will change for the better. JLL is a strong advocate of DCF and has used it across several sectors for a number of years.
There are clients who love DCF and those who do not always see the relevance but we think that the move to DCF is the right call by Pereira Gray. Globally, DCF is already adopted as a primary valuation approach in many markets, and we are learning from our colleagues around the world as to how they use it.
All our UK valuers have been trained to convert to a much more explicit way of valuing and specifically to understand how the market assesses discount rates and thinks about growth. We are talking to clients and colleagues across JLL to get the right datasets in our tool kit – there has never been a more interesting time to be a valuer.
Ollie Saunders is head of EMEA alternatives, valuation advisory, JLL
