MARKET VALUATION BASED ON DISCOUNTED CASH FLOW ANALYSIS

 - CONSISTENCY IN ASSUMPTIONS

Stellan LundströmRoyal Institute of Technology

Christina GustafssonIPD Norden

Background

• 1997 Establishment of the Swedish Property Index in co-operation with IPD

• A quality control process for index valuations

• An ambition that assumptions should be consistent

Data source

• 1997 – 2008: 24 000 Valuations

– 83 % with DCF technique

– All DCF assumptions and results are in a database

Main initial observation

• Valuation accuracy tested to be on a good level.

• Feed back on DCF parameters raises question about the relevance in assumptions about discount rates, exit yields, rents, vacancies, operations and maintenance

Research questions

Main question

”How are DCF assumptions related to each other

Specific question

”What is the meaning of DCF yields and discount rates when DCF is used for market valuations”

25

22

1917

1513 13

12 11 10 10

8

2 2

0

5

10

15

20

25%

The Swedish Leases– short and gross

Operation & maintenance cost as % of gross rent

Source: IPD Multi National Index Spreadsheet 2008

Office rents in Stockholm CBD

100

150

200

250

300

dec 1

997

dec 1

998

dec 1

999

dec 2

000

dec 2

001

dec 2

002

dec 2

003

dec 2

004

dec 2

005

dec 2

006

dec 2

007

New Letting IndexRenewals IndexValuation Market Rental Values Index

Source: IPD

Initial and long term vacancy rate in valuationsOffice Stockholm CBD, 1st January 1998 - 2008

0

5

10

15

20

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

%

= Assumptions in valuations long term

= Actual outcome = initial vacancy rate

Source: IPD

Assumed operations and maintenace costs in relation (%) to actual outcome

Sector / Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Retail 80 81 86 79 67 65 72 78 79 87

Office 91 94 82 79 69 64 67 73 78 88

Industrial 82 86 83 86 78 75 69 88 89 86

Residential 87 86 91 81 74 75 75 79 82 69

All Properties 88 89 85 80 71 69 71 75 80 74

Source: IPD

SectorActual/Valuations

NOI

Retail   80

Office   91

Industrial   82

Residential   87

All Properties   88

NOI year 2007

Source: IPD

6

6.5

7

7.5

8

8.5

9

9.5

10

5.5 6 6.5 7 7.5 8

Valuation yield (exit yield) %

Dis

cou

nt

rate

, %

Valuation of Office properties in Stockholm CBD 2004 - Discount rates and exit yields

Source: IPD

Year

Nominal Discount

rate

Nominal rental growth

Implicit Exit Yield

Explicit Exit Yield

in valuations  

  r gr-gA B A-B

1997 10.3 3.0 7.3 8.0 -0.71998 9.0 2.6 6.4 7.5 -1.11999 8.8 3.0 5.8 7.2 -1.42000 8.9 3.4 5.5 7.2 -1.72001 9.2 3.1 6.1 7.3 -1.22002 9.2 3.1 6.1 7.3 -1.22003 8.9 3.8 5.1 7.2 -2.12004 8.7 3.6 5.1 6.7 -1.62005 7.7 3.5 4.2 5.9 -1.72006 7.3 3.8 3.5 5.5 -2.02007 7.4 3.9 3.5 5.6 -2.1

Average 1997-2007 8.7 3.3 5.3 6.9 -1.5

Implicit vs explicit yields

Source: IPD

Average values for input variables in the valuations 1997-2007

n

NOI

%3.3g

%7.8r

%9.6

YieldExit

0 time

8.7 – 3.3 = 5.3 < 6.9

Conclusions

• ”All assumptions are biased – the result is OK!”

• The same discussion as 30 – 40 years ago

• Swedish valuers has developed;– An industry standard for valuation– A market monitoring system

Implications

• Valuers - legitimacy • Investors – Interpretation of and need for

decision support• Auditors– new role due to IFRS

– Opinion about • Market value (fair value)• Assumptions behind market value

• To value ”green buildings” there is a need for more explicit assumptions about NOI