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Direct capitalization or discounted cash flow analysis?

One issue that seems to attract increasing attention is whether the direct capitalization method (direct method) is too simplistic and subjective for valuing income properties in current markets. Many critics of the direct method advocate more use of discounted cash flow (DCF) analysis, claiming that DCF analysis is more sophisticated than the direct method and is gaining wider use among investors.

This article examines three major criticisms of the direct method compared with the performance of DCF analysis.


The following three major criticisms of the direct method are examined here:

* Real estate investors are using DCF analysis more and the direct method less. Because the income approach is supposed to simulate the way typical investors price properties, appraisers should make heavier use of DCF analysis.(1)

* Because the direct method deals only with first-year income, it inherently fails to deal with reversion and the variables that determine a property's income stream over its holding period.

* The process of adjusting market-extracted capitalization rates (cap rates) is too subjective.


The discussion that follows examines each of the three criticisms in relation to their impact on both the direct method and DCF analysis.


Surveys have been conducted over the years to determine how investors use profitability measures in the investment decision-making process. For example, the 1972 Wiley(2) survey of large, sophisticated investors found that cash-on-cash (i.e., cash flow divided by initial equity) was the single most important return measure, though 22% used some form of after-tax DCF model (internal rate of return |IRR~ was the most popular).

The 1981 Farragher(3) survey found that 62% of the 354 respondents used IRR. In second place was use of cash-on-cash at 51%. Only 16% used the direct method. The sample primarily consisted of large investors (e.g., life insurance companies, pension funds, syndicators).

The 1982-1983 Page(4) survey found that on a before-tax basis, IRR was used by 57% of the 101 respondents, followed by the direct method in second place at 45%. On an after-tax basis, IRR again was in first place at 50%. The respondents were characterized as "sophisticated real estate investors."

The 1986 Boykin(5) survey of 207 small, local investors in the Richmond, Virginia, area found that most reliance was placed on the direct method.

Finally, the 1985-1986 McIntosh et al.(6) survey of 32 corporate real estate executives (defined as corporations outside of real estate) found that 46% used IRR as their primary profitability measure. The simple, first-year measures such as cash-on-cash and the direct method were, as a group, tied for third place at 12%.

These surveys reveal two significant characteristics of investors: 1) a trend toward increasing use of DCF analysis, particularly among large investors; and 2) the fact that smaller investors tend to rely heavily on the simple, first-year measures such as cash-on-cash and the direct method.

One aspect that these surveys fail to investigate, however, is to what extent the computed profitability measure, whether a simple gross income multiplier or a more complex IRR, influences the final decision about whether to invest in a given project. If the price and terms seem reasonable and if the location, quality, and level of competition are acceptable, many investors assume that income will take care of itself if adequate property management is provided. How important the profitability measures are to investors in today's market is not really known.

In sum, the surveys cited suggest that small investors behave somewhat differently than large investors do when using profitability measures. Thus on the basis of the survey data one can argue that if appraisers are supposed to simulate the behavior of a typical investor, DCF analysis might be more appropriate when valuing large income properties, which are likely to be purchased by larger, more sophisticated investors. Similarly, the direct capitalization model might be more appropriate for smaller properties usually purchased by smaller investors. This is simply one observation and is not meant to suggest that the investor size should be the only criterion to determine whether to use the direct method or DCF analysis in a given situation.

Income stream and subjectivity

For brevity and convenience, the second and third criticisms are discussed together.

The multiyear DCF model, unlike the first-year direct method, unquestionably attempts to account for the variables that determine annual income and reversion value. In making the multiyear income projections, however, one must make informed assumptions about the value-determining variables, and here lies the inherent danger in the use of DCF analysis. For example, perhaps the most heroic assumption concerns reversion value; somehow an appraiser must try to estimate the proceeds from the sale of a property at the end of an assumed holding period. Further, when multiyear income estimates are made, who knows what the income and expenses will be, and what vacancy problems might be encountered?(7) To accurately forecast one year ahead in current markets is difficult, much less four to seven years ahead.

In addition, rent levels and vacancy rates are ultimately determined by the supply and demand for space. Both supply and demand are heavily influenced by location competition in the area; interest rates and the state of the economy; and the age, appearance, and condition of the property. Expenses are estimated by assuming a rate of inflation. If after-tax analysis is used, assumptions must be made about future tax laws and a typical investor's tax bracket. When these and other factors are considered, it is necessary to estimate whether the income stream should be level, variable, or increasing (or decreasing) in a systematic pattern. With this type of analysis an appraiser can prove anything with the right assumptions.

Reversion is a major potential benefit to an investor, yet as previously mentioned it is perhaps the most difficult benefit to estimate with any degree of confidence. To illustrate the impact of reversion within the DCF model, consider the example shown in Table 1.

This example represents an assumed five-year holding period for a 50-unit apartment building. A 15% yield rate was presumed appropriate. The main point, however, is that estimated reversion makes up a large percentage (i.e., 63.2%--752,264 / 1,190,531) of the estimated property value of approximately $1.19 million. A second point is that the reversion estimate is made five years into the future. To let a five-year estimate of eventual sale proceeds make up 63% of current estimated value is to build on a shaky foundation.(8)
TABLE 1 DCF Analysis Example

 Net Present
 Annual Value
 Operating Factor Present
Year Income at 15% Value

1 $ 131,700 0.8696 $ 114,526
2 $ 131,457 0.7561 $ 99,395
3 $ 130,825 0.5718 $ 86,050
4 $ 129,935 0.5718 $ 74,297
5 $ 128,720 0.4972 $ 63,999
Reversion $ 1,513,000 0.4972 $ 752,264

Total present value $ 1,190,531

Further, it is assumed that the sale will be a cash sale. This is frequently not the case, however, particularly in regard to smaller, harder-to-finance properties that are often sold using seller financing (i.e., installment sale). With seller financing, a seller will realize only a down payment on his or her equity, receiving the remainder of equity through monthly payments extending three to five years (or longer) into the future. Based on present values, an installment sale will affect reversion. This fact is ignored in the DCF model.

Once multiyear income and reversion estimates are made, a yield rate must be assumed. This rate is the yield a typical investor would expect to earn on the initial equity invested. It is a target yield, and although historical rates are relevant, one must be careful not to rely too heavily on them as indicators of future yield. Theoretically, a yield rate is a function of many complex, interrelated variables, including location, building condition and quality of construction, appearance, income, investor motivation, perceived risk, and luck. In short, the rate is a function of all of the variables that determine net income and reversion. An appraiser must thus select a yield that reflects rates currently anticipated by a typical investor. This is done by interpreting the attitudes and expectations of buyers, sellers, counselors, brokers, and the competition for capital in financial markets.

The contention here is that the process of deriving a yield rate is no less subjective than is the process used to adjust market-extracted overall cap rates in the direct method.

The DCF model, therefore, does indeed incorporate into its analysis the influence of some, but not all, of the variables that help determine the value of an income property. The direct method, which considers only first-year income, comes up short in this regard. When the issue of subjectivity is considered, however, it appears obvious that both methods require a substantial amount of subjectivity, even though they are quite different.


Although surveys reveal that over the past 10 to 15 years real estate investors have been moving toward increased use of the more sophisticated DCF analysis techniques, whether the computed results actually play a major role in the final investment decision-making process is still inconclusive. More research needs to be done to determine what role profitability measures plays in the final stages of the decision-making process.

Clearly, however, successful investors know that success in large part comes from "knowing the market" at all times. This of course includes full understanding of how prices are set in the market. Existing conditions demand heavy use of first-year, yet effective, profitability measures such as the direct method and cash-on-cash. This is because in the final analysis it is so difficult to obtain sufficiently reliable data to make the multiyear estimates required by the DCF technique.

It is true enough that investors may compute IRRs, net present values, and so on, but eventually one realizes that with the right set of assumptions about rent levels, vacancies, expenses, and reversion, almost any price can be rationalized. Thus essentially it is a matter of confidence in the numbers. The DCF analysis techniques may look impressive; may be "state of the art"; and may appeal to the intellect; there is no proof, however, that their use will actually improve an investor's performance. If the first-year numbers are acceptable and an investor is comfortable with the location, quality, and appearance of the improvements and sees some upgrading potential (e.g., renovation, better management), he or she typically assumes that income and value will increase under his or her ownership.

Finally, it is not being suggested here that the direct method is superior or inferior to DCF analysis. Both methods have their place in the appraisal process. Is it not, therefore, an appraiser's job to understand both methods and the marketplace well enough to know when either (or neither) is most appropriate for a given appraisal assignment? To insist that DCF analysis should be used just because it is more sophisticated is rather absurd. Nevertheless, whichever valuation method is chosen, it is not possible to avoid subjectivity, because an appraisal is ultimately an opinion of value.

1. There is a question as to whether the DCF method is actually a valuation method. According to the Standards of Professional Appraisal Practice of the Appraisal Institute, Guide Note 4, (Chicago: Appraisal Institute, 1990), D-9, DCF is a tool rather than a valuation method.

2. R. J. Wiley, "Real Estate Investment Analysis: An Empirical Study," The Appraisal Journal (October 1976): 586-592.

3. E. J. Farragher, "Investment Decision-Making Practices of Equity Investors in Real Estate," The Real Estate Appraiser & Analyst (Summer 1982): 36-41.

4. D. E. Page, "Criteria for Investment Decision Making: An Empirical Study," The Real Estate Investment Journal (Fall 1983): 38-50.

5. J. H. Boykin, "A Comparison of Evaluation Techniques Used by Appraisers and Investors," The Real Estate Appraiser & Analyst (Summer 1986): 59-63.

6. W. McIntosh, et al., "Capital Budgeting Practices of Corporate Real Estate Executives," The Appraisal Journal (January 1987): 125-135.

7. An exception might be a property with an AAA tenant on a long-term lease. In such a case income estimates should be reasonably accurate.

8. Although not shown in Table 1, indicated value is quite sensitive to the yield rate, just as indicated value is sensitive to the overall rate used in the direct method.

W. B. Martin, PhD, is currently associate professor of business and real estate at the University of Texas at El Paso. He received a BS in chemical engineering, an MBA in management, and a PhD in finance, statistics, and economics. Mr. Martin spent ten years in the petroleum industry before becoming a college teacher. In addition to conducting numerous market and feasibility studies for apartment and shopping center developers, he has published extensively.

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Author:Martin, W.B.
Publication:Appraisal Journal
Date:Jul 1, 1993
Previous Article:The valuation of owner-financed residential mortgages.
Next Article:Comments on discounted cash flow analysis.

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