Chapter 10:Chapter 10:BASIC MICRO-LEVEL VALUATION: "DCF" & “NPV”THE THE famousfamousDCF VALUATION DCF VALUATION PROCEDURE...PROCEDURE...1. FORECAST THE EXPECTED FUTURE CASH FLOWS;2. ASCERTAIN THE REQUIRED TOTAL RETURN;3. DISCOUNT THE CASH FLOWS TO PRESENT VALUE AT THE REQUIRED RATE OF RETURN.THE VALUE YOU GET TELLS YOU WHAT YOU MUST PAY SO THAT YOUR EXPECTED RETURN WILL EQUAL THE "REQUIRED RETURN" AT WHICH YOU DISCOUNTED THE EXPECTED CASH FLOWS.where:CFt= Net cash flow generated by the property in period “t”;Vt= Property value at the end of period “t”;E0[r] = Expected average multi-period return (per period) as of time “zero” (the present), also known as the “going-in IRR”;T = The terminal period in the expected investment holding period, such that CFTwould include the re-sale value of the property at that time (VT), in addition to normal operating cash flow.()()()TTTTrECFErECFErECFErECFEV][1][][1][][1][][1][00101020200100++++++++=−−ΛNumerical example...Numerical example...Lease:Year: CF:2001 $1,000,0002002 $1,000,0002003 $1,000,0002004 $1,500,0002005 $1,500,0002006 $1,500,000•Single-tenant office bldg•6-year “net” lease with a “step-up”...•Expected sale price year 6 = $15,000,000•Required rate of return (“going-in IRR”) = 10%...•DCF valuation of property is $13,757,000:)(1.1,000516+)(1.1,00051+)(1.1,00051+)(1.10,0001+)(1.10,0001+)(1.10,0001 = 165432000,000,000,000,000,000,000,757,3Why is the DCF procedure Why is the DCF procedure importantimportant??1.1.Recognizes asset valuation Recognizes asset valuation fundamentally dependsfundamentally dependsupon upon future net future net cash flowcash flowgeneration potentialgeneration potentialof the asset.of the asset.2.2.Takes Takes longlong--term term perspective appropriate for investment perspective appropriate for investment decisiondecision--making in illiquid markets (multimaking in illiquid markets (multi--period, typically period, typically 10 yrs in R.E. applications).10 yrs in R.E. applications).3.3.Takes the Takes the total returntotal returnperspective necessary for successful perspective necessary for successful investment.investment.4.4.Due to the above, the Due to the above, the exerciseexerciseof going through the DCF of going through the DCF procedure, procedure, if taken seriouslyif taken seriously, can help to protect the investor , can help to protect the investor from being swept up by an asset market “from being swept up by an asset market “bubblebubble” ” (either a (either a positive or negative bubble positive or negative bubble ––when asset prices are not related to when asset prices are not related to cash flow generation potential)cash flow generation potential)..Remember:Investment returns are inversely relatedinversely related to the price paid going in for the asset.e.g., in the previous example, if we could get the asset for $13,000,000 (instead of $13,757,000), then our going-in return would be 11.24% (instead of 10.00%):)(,000516+)(,00051+)(,00051+)(0,0001+)(0,0001+)(0,0001 = 654321124.100,1124.100,1124.100,1124.100,1124.100,1124.100,000,000,13vs.)(1.1,000516+)(1.1,00051+)(1.1,00051+)(1.10,0001+)(1.10,0001+)(1.10,0001 = 165432000,000,000,000,000,000,000,757,3What is the fundamental economic reason for this inverse relationship? [Hint: What determines fut. CFs?]Match the discount rate to the risk. . .Match the discount rate to the risk. . .r = rf+ RPDisc.Rate = Riskfree Rate + Risk Premium(Riskfree Rate = US T-Bill Yield.)First 6 years CFs are covered by an existing lease(contractual CFs). Other cash flows are more risky.DCF Valuation:Hypothetical office building net cash flows: Year 1 2 3 4 5 6 7 8 9 10 CFt $1 $1 $1 $1.5 $1.5 $1.5 $2 $2 $2 $22 Numerical example...Numerical example...() () ()()10107643115.120$15.12$08.15.1$08.11$000,058,13$∑∑∑===+++=ttttttHere we have estimated the discount rate at 8% for the relatively low-risk lease CFs (e.g., if T-Bond Yld = 6%, then RP=2%), and at 15% for the relatively high-risk later CFs (Î 9% risk premium).Î Implied property value = $13,058,000.10.2.2 Intralease & Interlease Discount RatesThe real difference in risk is between CFs covered by signed lease contracts, vs CFs expected (but not contractually certain) deriving from leases not yet signed. Once a lease is signed, the subsequent risk is reduced.More correct valuation of the previous property, with:• 8% = Intralease discount rate,• 15% = Interlease (& reversion) discount rate…() () () () ()10416463115.120$08.12$15.1108.15.1$08.11$000,453,13$ +++=∑∑∑=== ttttttCurrent practice usually is not this sophisticated for typical properties. If the lease expiration pattern is typical, a single“blended” discount rate is typically used. Thus, for this building, we would typically observe a “going-in IRR” of 13.13%, applied to all the expected future CFs… ()()()()1010764311313.120$1313.12$1313.15.1$1313.11$000,453,13$∑∑∑===+++=ttttttIn principle, this can allow “arbitrage” opportunities if investors are not careful (especially as the ABS mkt develops…Example:Suppose property with 7-yrs remaining on vintage lease but same expected CFs as before.Purchase for $13,453,000, then sell lease for $6,813,000 and property residual for $6,881,000, for a profit of $241,000:() ()()∑∑==++=6473108.12$08.15.1$08.11$000,813,6$tttt() () ()1031715.120$08.12$15.11000,881,6$ +=∑=ttValuation shortcuts: Valuation shortcuts: ““Ratio valuationRatio valuation””......1) DIRECT CAPITALIZATION:1) DIRECT CAPITALIZATION:A WIDELY-USED SHORTCUT VALUATION PROCEDURE:· SKIP THE MULTI-YEAR CF FORECAST· DIVIDE CURRENT (UPCOMING YEAR) NET OPERATING INCOME (NOI) BY CURRENT MARKET CAP RATE (YIELD, NOT THE TOTAL RETURN USED IN DCF)The idea behind direct capitalization…IF "CAP RATE" = NOI / V , THEN:V = NOI / CAP RATE(FORMALLY, NOT CAUSALLY)MOST APPROPRIATE FOR BLDGS W SHORT-TERM LEASES IN LESS CYCLICAL MARKETS, LIKE APARTMENTS.EXAMPLE:250 UNIT APARTMENT COMPLEXAVG RENT = $15,000/unit/yr5% VACANCYANNUAL OPER. EXPENSES = $6000 / unit8.82% CAP RATE (KORPACZ SURVEY)VALUATION BY DIRECT CAPITALIZATION:POTENTIAL GROSS INCOME (PGI) = 250*15000 = $3,750,000- VACANCY ALLOWANCE (5%) = 0.5*3750000 = 187,500- OPERATING EXPENSES = 250*6000 = 1,500,000------------------------------------- -------------------NET OPER.INCOME (NOI) = $2,062,500V =