Discounted cash flow vs. traditional valuation methodologies in Europe

What is considered the traditional valuation model?

Traditional valuation methodology is based on the capitalisation of future income streams by certainty and risk. One could, for example, opt for current vs. future market rent (“Term and Reversion”), or a split between the security of income tranches (“Core and Top Slice”). The capitalisation of income streams is done by All-Risk Yield, building in all future risks (inflation, property maintenance, and so on). This makes it an implicit valuation methodology. Traditional valuation methodology is heavily used in the United Kingdom.

How does the discounted cash flow (DCF) model differ?

DCF valuation calculates the present value of future cash flows generated by the asset, making it more detailed and forward-looking. Market forces like inflation are a significant factor in modelling future cash flow, and DCF takes this into account explicitly. This deeper insight however comes with its own challenges. As all assumptions are laid out and can be identified and quantified, it is an explicit methodology.

The argument for DCF valuations

Organisations today operate in a challenging, high-inflationary environment, and cash flow is typically where this additional pressure shows. While both a traditional methodology and DCF can be forward-looking, the explicit clarity given by the DCF model can be a positive for investors and is becoming the favoured model in some real estate circles.

Exploring the current European landscape 

The DCF model has gained a strong foothold in the Americas and Asia-Pacific, but Europe has a more fragmented landscape with greater contrasts. We’ve explored this before, but there are two key aspects to understand:

• Some European accounting and regulatory practices still favour traditional methods

• Sectors of the European market still rely on traditional methods primarily due to established industry norms

Perceived issues with DCF in Europe

DCF models rely heavily on accurate and comprehensive financial data/forecasts. In some European markets obtaining reliable data is an obstacle. Additionally, regulations and accounting standards vary over borders, making a truly standardised DCF model challenging. In some real estate valuations, there is also a scarcity of comparable transactions to establish discount rates and terminal values.

DCF models are also sensitive to the underlying assumptions used. These assumptions can be subjective and may vary between analysts or market participants, leading to divergent valuations. Accurate DCF models require a deep understanding of finance, forecasting, and valuation techniques. The shortage of experts with the necessary skills thus hinders their widespread adoption. DCF models are more complex and resource-intensive to build and maintain compared to traditional methods. Investors in Europe are beginning to shift favour to DCF models, appreciating the full value potential that they provide.

A changing environment

While adoption may not be as far along as other regions, we are witnessing a growing adoption of DCF within European borders. RICS’ recent consultation process on DCF valuation, combined with rising economic pressures and an increasing demand from global investors for more transparency are all contributing to the movement. Some additional factors also have a role to play:

• While both valuation models show essentially the same conclusions, the explicit methodologies used in DCF offer investors an easily accessible picture, enhancing its particular value

• For multinational businesses and global portfolios, it is critical to make “apples to apples” comparisons across regions, which is very easily achieved by using consistent DCF valuations

Traditional vs DCF: Which is best for your business?

The choice between traditional and DCF depends on your specific business nature and sector, the objectives the valuation must meet, data availability, and core industry practices. DCF is typically preferred by industry professionals in commercial real estate. This is based on the comprehensive nature of the assumptions, and the ability to better assess the long-term performance of a property.

This helps reduce the risk of unknowns and gives an inherently clearer idea of a property’s investment value. The ability to run ‘scenario analysis’ is helpful in making educated investment choices. While there are some limited cases in which traditional valuation may still be favoured, DCF is a versatile and future-forward choice for the industry.

Why the use of DCF is rising in real estate

In general, DCF is more effective for asset types with high growth and uncertain cash flows. DCF is frequently used by investors in private equity and venture capital because it enables them to model the expected returns from investments over time.

DCF offers a valuable advantage in the flexibility and accuracy it offers for property valuations. This allows it to reflect the key characteristics and risks of a property, from tenant mix and lease terms through to growth potential. It also offers a range of values for properties under different conditions, such as changes in occupancy, capital expenditure, and even exit strategies. In a challenging high-inflationary environment that impacts the cash flow of an asset, it can be difficult to assess this risk using traditional valuation methods. Hence the rising demand for DCF analysis instead.

However, traditional methods are often still preferred in mature industries with stable cash flows and a history of consistent performance. Methods like price-to-net asset value (P/NAV) and residual methodology, for example, are often used for shopping centres and real estate developments.

Does it make sense to employ both?

It can make sense to employ both methods in parallel in real estate under very specific circumstances, such as a transition period in methodology choice. This helps assure any remaining reluctant investors and third parties that they are receiving the same conclusions, simply in a different way. However, this amounts essentially to ‘doing the work twice’ for little additional value gain and should be utilised for a limited period only.

To make informed investment decisions, it's essential to consider the changing landscape and adapt valuation methods accordingly. The shift to DCF from traditional valuation methods has already gained a strong following in international markets, adapting to rising inflationary market pressures, and is fast on its way to becoming a real estate industry standard in Europe as well.

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