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Hot Topic Highlight – RICS Professional Standard Discounted Cash Flow Valuations (1st Edition)



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What is this week's blog about?


In this week’s blog, we take a look at the RICS Professional Standard Discounted Cash Flow Valuations (1st Edition). This is essential reading for all RICS APC and AssocRICS candidates with Valuation as a technical competency, as well as qualified surveyors and RICS Registered Valuers.


What is a DCF?


RICS (2023) define a DCF as ‘a valuation model that seeks to determine the value of real estate investment property by examining its future net income or projected cash flow from the investment and then discounting that cash flow to arrive at an estimated current value of the investment’.

You can download a full copy of the Professional Standard on the RICS website.


RICS provide a glossary of other helpful terms relating to DCFs on pages 3 to 6 of the Professional Standard.


What does this Professional Standard relate to?


The Professional Standard relates to the use of the explicit DCF method (under the income approach in VPS 5 of the Red Book Global) to value investment property. Investment property includes all income-generating asset types (e.g., commercial and residential) and both occupied and vacant property.


Investment property can be valued using both implicit and explicit forms of the investment method of valuation.


‘Traditional’ implicit valuations use comparable evidence to inform rental value (at current levels) and a market yield (where risks and rewards, such as rental growth) are built implicitly into the choice of all risks yield), arriving at capital value. The use of an implicit calculation would be appropriate where there is strong, consistent market evidence and ideally where the valuation scenario is fairly simple.


Explicit DCF valuations, by contrast, use a cashflow and explicit assumptions around a variety of inputs, such as rental growth, to arrive at capital value. Although more complex, DCFs can be used to more accurately model a wider variety of scenarios and assumptions, including unique assets or where comparable evidence is inconsistent or limited.


Essentially, a DCF converts a series of future cash flows to a single current value, i.e., they are discounted back to the valuation date.


Valuers could also use both methods to value an asset, with the outcomes compared and cross-checked. Two methods can, therefore, be used to benchmark each other. If adopted correctly with valid, reliable assumptions and inputs, then the two outputs should be similar (assuming the basis of value is the same).


How does this relate to VPS 4 of the Red Book Global?


The Professional Standard discusses the differences between VPS 4 Market Value and Investment Value.


An explicit DCF can be used to derive both of these valuation bases; with Investment Value being the value to a specific investor or owner, rather than the Market Value to the market as a whole. The distinction is helpfully defined, with Market Value being what you need to pay and Investment Value being what you should pay (or what it is worth).


If assessing Market Value, however, using a DCF – then all of the inputs should be market-based and not specific to one investor or stakeholder (as this would instead relate to the assessment of Investment Value).


We recommend reading Sections 4 and 5 of the Professional Standard to find out more about how to use DCFs to assess both bases of value. This includes deciding on the inputs you will use, such as rental value, holding period and discount rate.


Appendix A provides example calculations, which will be helpful to valuers when applying implicit and explicit investment valuation calculations. Appendix B provides guidance on risk analysis techniques, such as sensitivity analysis, scenario modelling and simulation, whilst Appendix C deals with depreciation and obsolescence.


What does a DCF look like?


A simple DCF calculation is shown below. The key inputs you would need to establish in this scenario are the current market rent, expected rental growth (% p.a.), rent review period, holding period, discount rate and all risks yield (for the last line of the cashflow into perpetuity).



Do I have to use DCFs going forward?


No…the valuer needs to use their professional judgement to decide on which valuation approach and method isEdition).hisshis hi.hpriate. RICS are encouraging valuers to be explicit and transparent in their valuation methodology, as per the requirements of VPS 5, however.


 

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Stay tuned for our next blog post to help build a better you.


N.b. Nothing in this article constitutes legal, professional or financial advice.


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