The discounted cash flow method is a model for calculating enterprise and property values and can be used to assess investment decisions.
The DCF method has its origins in the theory of the dynamic calculation of development costs. In company valuation, the DCF method is used in the WACC method, the APV method, the total cash flow method and the equity method.1
In property valuation, the DCF method is a growth explicit model.2
This method is used in the English-speaking world to calculate the market and fair values of properties. In Germany it is also regularly used to calculate fair value, especially for international investors.3
However, it is not covered by the Immobilienwertermittlungsverordnung (ImmoWertV – German Property Valuation Ordinance) and is therefore not legally accepted. It merely has a certain resemblance to the “income approach on the basis of periodically different income” in accordance with section 17(3) ImmoWertV.4
In addition to valuation it is mainly used also internationally – on the basis of projected income – as a net present value method for profitability analysis of property investments.
Operation in calculation of fair value:
The DCF method can be divided into two phases. The forecast phase covers a period of ten to 15 years. The future income and all factors associated are forecast and discounted to the valuation date using a previously determined discount rate.5
The discount rate is not the same as the property interest rate as in the standard German income method, but is instead derived from matched risk investments.6
In the second phase, the so-called residual value phase, the residual value is determined using a multiplier in accordance with the remaining useful life. The multiplier is derived from the discount rate of the forecast period reduced by the expected growth rate in rent. The DCF method can be formally presented as follows:
Figure: Formula of DCF method
Source: Matthias, Thomas unter Mitarbeit von Brauers, Maximilian; Hocke, Stefan (2011): Immobilienbewertung. In: Rottke, Nico B.; Thomas, Matthias: Immobilienwirtschaftslehre Band I. Management, Köln, S. 810-811.
FCF = free cash flow
i = discount rate
n = years
RV = residual value
The free cash flow is, in principle, the annual, periodically varying net income of a property. This allows a higher level of detail and increased transparency compared to the German income approach.7
However, owing to the uncertainty of future cash flows, it entails a corresponding uncertainty factor.
The DCF method in property valuation can be visually shown as follows:
Figure: DCF method
Source: Own diagram
Operation in the calculation of development costs:
In the calculation of development costs using the DCF method, the net present value and internal rate of return are calculated from the cash flow presentation over the selected forecast period, which is usually the holding period of a property investment, in order to decide the economic viability of a property investment.8 Other indicators can be derived relatively easily from this process. Different investment opportunities can also be compared with each other on a uniform basis, which makes the DCF method an extremely popular analytical tool in the global property industry.