Real-Time Valuation DCF

Traditionally, real estate investors have performed discounted cash flow analysis by assuming operating income projections and a terminal value, and then discounting all cash flows back to a present value.  The answer to which discount rate to use was often answered by using the risk free rate and then adding a risk premium representative of “real estate” type risk.   Thus, a single discount rate was used regardless of how distant in the future the flows occurred and how weak or strong the property’s tenants were relative to the “typical” tenant credit profile.

So if the acquisition game is about culling out the nuanced differences between seemingly similar assets (at least on the surface), why would a valuation methodology treat cash flows, differing in timing as well as quality, in the same fashion?  Doesn’t make any sense and may lead to missed opportunities or unfulfilled expectations.

A “Real-Time Valuation” (RTV) model , Young (2006), can be a superior approach to differentiating cash flows from multiple assets competing for your capital.  The basic idea behind RTV is to incorporate the term structure of interest rates, as expressed by the Treasury yield curve, as the risk free rate, and then adding a tenant risk premium for each tenant on the rent roll.  A rating system of A through E is developed and specific rates are assigned to each rating category.  The ratings and the rates are based upon the analyst’s intuitive feel of the tenant risk profile compared to the general tenant market.  The blended, overall tenant risk rating is then added to an interpolated monthly Treasury yield, and together they serve as the monthly discount rate.  Although Young suggests to account for rollover leases into perpetuity to obtain the value of future leases, I suggest building in assumptions about the re-leasing and lease up of vacant space, and terminal value, then discounting those cash flows at the monthly rate and value at the developed discount rate at the time of the projected sale.

Although valuation is the primary focus of RTV, yield measures, explicit risk measurement and assessment, lease and property duration, and elasticities or sensitivities with respect to changes in either market rent or discount rate are additional benefits that come from the model and pointed out by Young.  The implications for real estate investors are that the RTV model allows measurement of significant differences in the risk and performance characteristics of individual properties not seen in conventional analytical techniques.