Geltner Chapter 10

Geltner et al. (2007)
Chapter 10: DCF & NPV

[pic 1]Introduction

Each side in a potential deal will almost always be willing to ‘‘do the deal’’ at some price. So the question boils down to, at what price? In other words, how much is the asset worth?

[pic 2]10.1 RELATION BETWEEN RETURN EXPECTATIONS AND PROPERTY VALUES IN THE ASSET MARKET

• Establish the link between the expectation of returns, which motivates investors, and the prices or values of assets, which is the issue they are most directly grappling with in the day-today business of real estate investment:

• The prices investors pay for properties determine their expected returns, because the future cash flow the properties can yield is independent of the prices investors pay today for the properties.

• The expected return is inversely related to the price of the asset, because the expected future cash flows from the asset (including the resale) remain the same, no matter how much you pay today for the asset. They remain the same because they are determined by factors that are independent of how much you pay today for the asset.

• Future rents are determined by supply and demand in the space market. The resale price you can reasonably expect is determined by the future rents the next buyer can expect going forward and by the opportunity cost of capital (the next buyer’s required expected return) at the time of your re-sale. Neither of these factors—neither the equilibrium in the space market nor that in the capital market—is influenced by the price you pay today for the property.

• Greater Fool Theory: you don’t need to worry about paying too much for a property because, even if you have been foolish and paid too much, it is unlikely that you are the stupidest person in the market. Thus, you can always count on finding a greater fool who will pay at least that much again and rescue your ex post return.

• The Greater Fool Theory would lead, by definition, to a disconnection between asset prices and the underlying fundamental cash flow generation potential of those assets. Such a disconnection is the definition of an asset price ‘‘bubble,’’ in which prices grow over time only because each buyer expects such growth, unrelated to the underlying physical productive potential of the assets. (Tulip Bulb Bubble)

[pic 3]10.2 DISCOUNTED CASH FLOW VALUATION PROCEDURE

• The basic investment valuation framework known as multi period discounted cash flow valuation (or just DCF for short) has gained wide acceptance in recent decades, both in academic circles and in professional practice. DCF is probably the single most important quantification procedure in micro-level real estate investment analysis. In essence, the procedure consists of three steps:

• Forecast the expected future cash flows. [pic 4]
• Ascertain the required total return.
• Discount the cash flows to present value at the required rate of return.

• Mathematically:

10.2.1 Match the Discount Rate to the Risk: Intralease and Interlease Discount Rates

• In the DCF valuation procedure, the discount rate serves to convert future dollars into their present value equivalents. This requires accounting for both the time value of money and the risk in the expected future cash flows.
• The total return can be broken into a risk-free interest component and a risk premium component: r = rf + RP. The risk-free interest rate component accounts for the time value of money, and the risk premium component accounts for the risk.
• Intralease discount rate: The relatively low discount rate used to convert cash flows across time within leases. Cash flows within signed leases are fixed contractual obligations of the lessee, and therefore do not subject the landlord to rental market risk. Such projected cash flows should thus normally be discounted at a lower rate within the lease (that is, subsequent to the signing of the lease).
• Interlease discount rate: Conversion of projected future cash flows or values to present value across time prior to when the future values are contractually fixed would be made using a higher ‘‘interlease discount rate’’ that reflects the property’s rental market risk. The interlease discount rate would normally apply to determine the present value both of the future long-term leases not yet signed (discounted to present from the time of their projected future signing), as well as of the residual or reversion cash flows representing projected proceeds from future resale of the property.        
  

10.2.2 Blended IRR: A Single Discount Rate

• Another consideration is that it is often not precisely clear what the different discount rates should be. Uncertainty over the correct discount rates takes some of the motivation out of the desire to be methodologically correct. Finally, if a property has a pattern of lease expirations over time, which is typical for buildings of its type, then one may apply a single blended IRR rate as a legitimate shortcut.
• To use the blended IRR, simply compute the IRR for the cash flow stream you’re dealing with (Excel might help).
• The use of separate, explicit interlease and intralease discount rates is not widespread in current DCF valuation practice. We have introduced the concept here partly for pedagogical reasons, to deepen your understanding of the fundamental sources of commercial property value and to build your intuition about how to apply the DCF technique. How precisely it is necessary or possible to match discount rates with different risks in the cash flow components is always a judgment call. In the real world, separate rates are typically used only when special circumstances exist, such as when a building has a long master lease or other atypical lease expiration pattern.

[pic 5]10.3 RATIO VALUATION PROCEDURES: DIRECT CAPITALIZATION AND GIM AS SHORTCUTS

• If you are interested in shortcut valuation techniques, an even shorter shortcut is widely used in practice, known as direct capitalization. With direct capitalization, the property’s initial year net operating income alone is divided by the cap rate to arrive at an estimate of the property value. The multiyear cash flow projection is skipped.
• Another shortcut valuation procedure is to apply the gross income multiplier (GIM) to the gross income of the property rather than applying the cap rate to the net income.8 The GIM is particularly useful for valuing small properties where one can estimate the gross revenue with relative ease and reliability, based simply on observation of the prevailing gross rents in the relevant space market, combined with knowledge about the size and rentable space in the subject building. Information on the building’s operating expenses and, hence, net income, may be more difficult to obtain, or viewed with more suspicion, as its only source may be the current property owner who is trying to sell the building.
• Both the cap rate and the GIM are examples of ratio valuation; in which a single year’s income or revenue from the property is multiplied (or divided) by a ratio to arrive at an estimate of the current asset value of the property.

[pic 6]10.4 TYPICAL MISTAKES IN DCF APPLICATION TO COMMERCIAL PROPERTY

• A few mistakes are quite common inthe application of DCF to commercial real estate.
• GIGO mistake: Garbage In, Garbage Out.’’ The point is, a valuation result can be no better than the quality of the cash flow and discount rate assumptions that go into the right-hand side of the DCF valuation formula. (that is, the ‘‘math all adds up’’). Prevalent GIGO mistakes:

• If Your Case Lacks Merit, Dazzle Them with Numbers
• Excessive Laziness

• The required return (the discount rate) should generally be found by considering the capital markets, including the likely total returns and risks offered by other types of investments competing for the investor’s dollar. The required expected total return (E[r]) should be thought of as the opportunity cost of capital and should represent the going-in IRR investors could expect from alternative investments of similar risk.

[pic 7]10.5 IS DCF REALLY USEFUL IN THE REAL WORLD?

• Successful real estate investment decision makers may go through the motions of DCF analysis for the sake of pro forma requirements of outside investors, but they do not really use the DCF procedure in actually making their own investment decisions.
• Rather, these decisions seem to be made on the basis of much more ad hoc or seat-of-the pants analyses and calculations, where non quantifiable or barely quantifiable intuition reigns supreme.
• In fact, if the DCF procedure is correct in principle, yet not used in practice, then surely its use in practice holds the potential to improve decision making. In essence, the DCF procedure differs from simpler, more ad hoc approaches in that it makes explicit the long-term, multi-period, total return perspective of investment performance. Few commercial real estate investors would admit to not being really interested in this perspective. Use of DCF does not preclude or supersede the application of insight and intuition. Quite the contrary. The correct and careful application of DCF should generally be able to provide insight and enlighten intuition.

[pic 8]10.6 CAPITAL BUDGETING AND THE NPV INVESTMENT DECISION RULE

• To make good micro-level investment decisions, here is what the NPV rule says to do:

• Maximize the NPV across all mutually exclusive alternatives.
• Never choose an alternative that has: NPV < 0.

• The beauty of the NPV rule lies in its elegance and simplicity, and its intuitive appeal. The power of the NPV rule derives from the fact that it is based directly on the fundamental wealth maximization principle.
• To clarify the link between the DCF valuation procedure and the NPV decision rule, it may be helpful to express the NPV for the typical commercial property investment decision as follows:

• If buying: NPV = V - P
• If selling: NPV = P - V
• (V=value of property at time zero, based on DCF; P=selling price of property)

10.6.1 NPV Rule Corollary: Zero-NPV Deals Are OK

• Zero-NPV deals are not zero-profit deals, in the sense that, if the discount rate accurately reflects the opportunity cost of capital, it includes the necessary expected return on the investment.
• Zero NPV simply means that there is not supernormal profit expected. A zero-NPV deal is only ‘‘bad’’ if it is mutually exclusive with another deal that has a positive NPV.
• if the NPV is defined on the basis of the market value of the asset in question, then the NPV on one side of the deal (e.g., that of the seller) is just the negative (or opposite sign) of the NPV on the other side of the deal (e.g., that of the buyer). Market value, which we will label MV for short, is by definition the price at which the property is expected to sell in the current asset market. This is therefore also the price a buyer must expect to pay to obtain the property. Thus, from this perspective:

• NPV(Buyer) = V - P = MV – P
• NPV(Seller) = P - V = P - MV = -NPV(Buyer)

• Now if both the buyer and the seller are applying the NPV rule, then they both require NPV > 0. But as we saw in the earlier equations, this requirement can only be satisfied simultaneously on both sides of the deal if NPV=0. That is:

• (i) NPV(Buyer) > 0 → –NPV(Seller) > 0 → NPV(Seller) < 0
• (ii) NPV(Seller) > 0 → –NPV(Buyer) > 0 → NPV(Buyer) < 0

→(i) & (ii) together → NPV(Buyer) = NPV(Seller) = 0

As long as we are evaluating the NPV based on market values, then a zero NPV is actually what we would expect.

10.6.2 Choosing Among Alternative Zero-NPV Investments

• How is an investor to decide among alternative deals if they all seem to present an NPV of zero, evaluated honestly? There are two major answers to this question:

• The first has to do with the difference between ‘‘market value’’ and ‘‘investment value.’’
• The second way investors may rationally decide among alternatives that have equal (zero) NPVs is similar to the kinds of investment decisions that investors in the stock market must make all the time.

10.6.3 Hurdle Rate Version of the Decision Rule

• An alternative version of the NPV decision rule—preferred by many decision makers—expresses the decision rule in terms of the investment’s expected return (typically a single blended IRR rate) rather than in terms of its NPV. The IRR version of the investment decision rule is as follows:

• Maximize the difference between the project’s expected IRR and the required return.
• Never do a deal with an expected IRR less than the required return.

• As always, the required return is the total return including a risk premium reflecting the riskiness of the investment, the same as the discount rate that would be used in the DCF valuation of the investment described in Section 10.2. This required return is referred to as the hurdle rate.
• Beware alternative interpretations as well as the major pitfalls of the IRR rule