Discounted cash flow (DCF) adoption trends in Europe

In recent months, property companies have been adopting the discounted cash flow (DCF) methodology at a greater rate than ever before. Just a year ago, this approach to valuation – which estimates the value of a real estate investment using its expected future cash flows – was the methodology of choice for only a handful of fund managers. This trend has been particularly noticeable in the Pan-European open-ended space, where investor demand for increased transparency on valuation movements has driven fund managers to mandate DCF adoption from their 3rd party valuers. DCF is the main valuation standard in the US and global investment players are also key influencers in EU DCF adoption.

The factors behind the uptake of DCF across a wider audience has undoubtedly been helped by the RICS’ consultation process, which stems from its recent review of real estate investment valuations, and the general landscape of economic uncertainty ushered in over the last two years by the pandemic. Moreover, one of the key agenda items for RICS is to ensure that explicit and transparent assumptions are contained with 3rd party valuations so as to provide greater accuracy and overall confidence for those relying upon them. Based on the outcome of the consultation process, RICS will need to consider potential changes to its Red Book, which is the standard under which Chartered Surveyors undertake their valuation work.

As historically high levels of inflation influence index-linked leases, fund managers are frequently scrutinized by investors about the extent to which it is influencing cash flow increases versus management initiatives or CapEx spend that has been, or will be, invested in the property. This is granular detail that DCF provides, offering transparency as to a range of factors that dictate values.

While gaining such visibility is undeniably important in the current macroeconomic environment, having access to greater amounts of information about a property is arguably becoming more imperative. Changes in the way occupiers work or run their businesses mean certain properties (such as offices and retail), are more difficult to lease than others for a range of reasons, including structural changes, that make value-creation a more complex task.

It’s also important to acknowledge the pressing need for properties - across sectors - to be repositioned in order to bring them into line with the latest environmental standards. For some properties, their ability to be upgraded according to emerging ESG guidelines is the difference between being let or facing obsolescence. It is crucial, therefore, to plot the extent to which the level of CapEx would add value over the lifecycle of ownership, or how void periods incurred as a result of extensive work will have impacted the income at different points in time. By contrast, the traditional approach is far less transparent and less granular, thus Iimiting the insight on the impact of specific CapEx strategies.

This is not only of use to the owner itself but to those who need to assess business performance; prospective lenders at refinancing, for instance, which are placing evermore value on the need to create secure rental income over the long term as capital values come under pressure.

For these reasons, Pan-European fund managers have also started embracing DCF. Such managers are often running a number of real estate investments across countries and sectors subject to different local valuation practices which has made it more challenging to have a consistent consolidated view of asset performance. The roll-out of DCF (along with standardised modelling policies) across the board enables a more consistent approach with the ability to perform detailed analytics and better compare asset performance.

With the uptick in DCF adoption, these managers will be able to better understand the tangible actions they can be taking that will lead to value creation. And with the current climate of uncertainty and the declines in valuations, this can only stand to benefit the industry at large.