Discounted cash flow and the investor driven movement to more sophisticated valuations

Altus Group recently hosted a webinar, The DCF Valuation Methodology and its Adoption in Europe, inviting valuation experts from the industry to discuss the emergence of DCF. On the panel was Pierre Buchet, International Partner, Head of International Cross Border EMEA Valuation & Advisory at Cushman & Wakefield and Lloyd Harrison, Associate Director, Fund Analysis at Invesco. Joining them from Altus Group included Nicolas Le Goff, Head of Advisory EMEA and Julien Sporgitas, Strategic Client Partner.

DCF is a valuation method more commonly used in North America and Asia Pacific, that estimates the value of an investment using its expected future cash flows and strives to determine the value of a real estate asset according to this metric – a depth of analysis investors in the UK and Europe are increasingly craving, says Buchet.

Buchet explains: “It is very important [for investors] to understand where values are coming from and DCF helps us go into more detail where you can look at voids, cap-ex, inflation and growth – you can be explicit,” adding that due to this the “industry is on the path to adopting DCF.”

Figure 1 - Poll results: What has been the biggest barrier to DCF adoptions in your view?

Le Goff confirmed that Altus Group has seen an increase in DCF requests from clients. He said: “DCF opens the door to a much more powerful analysis…the granularity of the model allows you to understand how much value is driven by inflation, how much is by value growth” and provides clients with the ability to compare those outcomes with other assets in a portfolio.

In Harrison’s view the traditional model had not been suitable in recent months. He explained: “In the high inflationary environment that we had over the last year, we started to see a couple of discrepancies, where because inflation was not modeled into properties that had hurdle rates in their lease contracts, there was a bit of a fudge in the traditional valuation methodologies to try and overcome this.”

Figure 2 – Poll results: What do you feel are the main benefits and opportunities of implementing DCF

But DCF is also gaining traction due to the increasing sophistication among investors, Harrison added, explaining that this fact was behind the investment manager’s recent decision to transition its portfolio to DCF-based analysis. Being able to provide DCF metrics in response to clients’ enquiries has, he said, been “massively beneficial” for the company because its investors already use the methodology across North American and Asia Pacific investments. He added that his clients are also using DCF to value assets other than real estate, meaning they are able to view their portfolios according to the same metrics.

Such alignment, said Sporgitas, is a major advantage of the growing acceptance of DCF in the UK and Europe. “There’s a strong case for DCF in the sense it gives global investors the ability to compare a portfolio geographically and do a bit of a deep dive. It provides transparency.”

But another opportunity, the panel reflected, is that the methodology helps build trust between valuers and their clients. The quality and breadth of information contained in a DCF analysis helped bring more knowledge to a discussion around values, Buchet explained. While Harrison said DCF allowed insight into the assumptions used in a valuation and why growth expectations are as the metrics indicate. Sporgitas added in this respect, DCF would increasingly be used as a business planning tool because it allows clients to model for a variety of values using differing assumptions.

Figure 3 – Poll results: In 2023 what has been your firm’s approach to DCF

To hear more of the discussion in full, here is the recording of the webinar:

Solutions to data challenges

Panelists also delved into the challenges of DCF, citing the difficulty over the lack of data from the European real estate industry as one obstacle, another being the use of multiple methodologies across the Europe making it difficult to achieve consistent data points. Le Goff also reflected solutions to the obstacles he has encountered in using the methodology, specifically around the issue of modelling discount rates with certainty. But explained that in his experience, that transparency is key.

Buchet and Harrison suggested that traditional methods were valuable as a sounding board to help in verifying and cross-checking DCF calculations. “You have to prove your valuation is embedded in the market,” Harrison explained, adding: “It is important to look at the DCF against a quoted initial yield and see if it makes sense.”

Figure 4 – Poll results: What was the primary reason for your organization to adopt DCF

Looking to the future, the panel said clients are likely to continue embracing DCF analysis and requesting its use by valuers in the UK and Europe. There was consensus that the educational process is underway within the valuation profession, and they predicted that the barriers to DCF adoption would be fewer than people expect. Closing the discussion, Sporgitas concluded: “Ultimately investor demand prevails…real estate is going to adapt and we will adapt.”