Why now is the time for a better approach to valuation in the UK and Europe

In the next few weeks, the RICS will close the consultation on its review of the valuation profession, reforms that will make significant changes for valuers and clients alike. One of them is the adoption of the use of discounted cash flow (DCF) as the primary method of preparing property investment valuations in the UK and Europe.

Part of the logic behind this recommendation was that the industry is becoming what the report’s author, Peter Pereira Gray, termed as “increasingly discerning” about how valuation outcomes are arrived at and increasingly critical of the traditional methodology used.

The rigour that Pereira Gray rightly identifies is only going to intensify as the property industry navigates challenging, complex times, where granular detail and transparency will be essential for supporting business decisions and providing those analysing them - such as lenders and investors – with confidence.

The RICS, and those property investors already making the shift to DCF valuation approaches, are attempting to remedy the fact that valuing properties in the UK and Europe is not done on the basis of one standard method but many, and with varying levels of transparency. Such fragmentation is a problem for global fund managers, for instance, in aggregating data or comparing properties across a portfolio. But there is another reason why DCF methodology as a standard would be more robust.

A property value that is arrived at via a traditional valuation methodology (the dominant approach in the UK) cannot be – as Pereira Gray terms it – “fully rationalised mathematically”. Instead, it takes an all-risk initial yield approach which focusses on initial equivalent and reversionary yields, resulting in a scenario in which, he adds, “may not accord with the actual rents paid” or may overlook the future value of an asset.

In a risky commercial property market DCF provides needed transparency

At a moment in the market where cash flow analysis is imperative, a DCF methodology would be the most rigorous way for an investor to laser in on this aspect of an asset value. This is because all of the cash flow is predicted on a standard basis, usually 10 years (though it could be five or 15).

In being able to break down all the elements that will influence that cash flow, it is possible to more accurately analyse how inflation, for instance, would influence that data point.

Those using DCF during the pandemic will have also been at an advantage. A time when lockdowns meant some properties – such as shopping centres or hotels - were not able to collect income at all, or only intermittently, a DCF valuation would have been a window into the impact that stress meant for values.

And now that, in the wake of the pandemic, retail tenants are moving to turnover rents, a traditional method is not structured to provide insight into the value that this kind of lease brings to a property’s overall worth.

Of course, no method is perfect, and DCF is not a crystal ball. But it does provide a basis upon which more rational assumptions can be made at a time when rationality around risk is key.

A recession will, or could, create occupier stress. So any owner preparing an asset for refinancing, sale or hoping to attract equity partners, will need extensive insight about net operating income against a range of stress factors. Such mathematics will be crucial in assessing the ability of cash flow to cover debt obligations, for those lenders increasingly analysing debt service coverage ratios.

DCF is ideal for valuing operational assets

But it is also a method fit-for-the future, one where operational assets with fluctuating income are commonplace. Hotels, residential (which is already typically valued using DCF, even in the UK), healthcare and student accommodation are becoming ever-established asset classes and attracting more investment.

For properties like these, being able to project value based on a variable income stream will be critical. It also, crucially, recognises the possibility that a property asset in the hands of one operator might have a different prospective return in the hands of another, as the RICS review points out.

The RICS intends to make some of Pereira Gray’s recommendations mandatory by 2023. A number of our clients have already made headway in requesting that their valuers switch to] a DCF methodology in anticipation of this.

As more property investors do this, it will support any fine-tuning that needs to take place and valuer’s expertise will be as critical as ever in supporting that. But a wide adoption of this methodology will also generate the necessary volume of transactions needed to bring standardization and transparency to the market.

In the course of this learning curve, we are here to help clients, and model best practices to support a more harmonised, detailed approach to property values. There is much uncertainty around – most of which is not in the industry’s control – but through DCF, the industry does have a way to better equip itself to shine a light on several important facts.