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Unbundling the cash flow: beyond the property internal rate of return.

Risk-return relationships are often critical to the proper valuation of income-producing real estate. This article presents a method for the analysis of the individual components that create value, which can be used by valuation, investment, and lending analysts to identify the characteristics of a cash flow valuation. The resulting unbundled cash flow analysis will help analysts to develop an adjusted overall property internal rate of return, or ultimately, a risk-adjusted rate of return associated with each of the valuation components that contribute to value.

In the literature on property measures of performance risk, various authors have endeavored to articulate methods or suggest considerations for reviewing the appropriate rate of risk (i.e., return) associated with a given real property investment.(1) A recently published article, "New Measures of Future Property Performance and Risk" by D. Wylie Greig and Michael S. Young, suggests "a methodology for establishing performance expectations for multitenant commercial properties based on the character of existing leases."(2) The concept expressed in the Greig and Young article can be applied to the valuation of any income-producing property.

In this article, the appraisal, investment, and underwriting communities are presented with a method for reviewing the individual components that create value in a cash flow analysis. The process can be employed in conjunction with the lease-by-lease cash flow analysis typically supplied in a multitenant property valuation/evaluation. Further, it is intended to serve users as well as analysts in reviewing the risk relationships of value components as indicated by the discounted cash flow (DCF) analysis.

Rather than challenge the reliability of forecasts, the purpose of this article is to "unbundle" the components in the cash flow in a manner that identifies the impact of each contributing income stream. The results may indicate that certain combinations of unbundled cash flows represent a preferred value mix or meet specific portfolio criteria. Analysts and users of the cash flow analysis will then be able to review the disaggregated components of the value and evaluate the appropriate level of overall risk, leading to more informed investment decisions.


Traditionally, the value of a property, as suggested in DCF analysis, result from the application of a series of complex rental assumptions(3) to the individual tenant areas, both existing (i.e., contract) and forecast (i.e., speculative). An investment holding period is assumed, with sale (reversion) of the asset in the final year of the forecast. The indicated value from DCF analysis is equivalent to the present value of the periodic cash flows plus the reversion (at a single discount rate).

Traditional cash flows reveal a single, combined income stream that accounts in total for the leases under contract, speculative leases, and reversion. A limitation of such a combined cash flow is its inability to readily make apparent the relative contributions of the individual components. As a tool to assist users and analysts in reviewing the components of value, a methodical segregation of the cash flows is suggested. For analytical purposes, the overall property discount rate has been used initially in the following examples to evaluate the value of individual components, as opposed to the application of differing rates. The individual components of value to be segregated in the analysis are defined as follows.

* Existing leases--the present value attributable to the existing contract leases after an appropriate deduction for the pro rata share of expenses.

* Speculative leases--the present value attributable to the assumed re-leasing after the expiration of all existing leases, following a reduction for the pro rata share of expenses. (The tenant improvements and leasing commissions are all offset against this value component.) This value component also includes the present value of any net income resulting from the lease-up of currently vacant space.

* Indebtedness--the present value of any reduction in indebtedness over the holding period.

* Reversion before appreciation or depreciation--the return of the original investment at the property discount rate. This component is calculated by discounting the current property value estimate in DCF analysis as if it were the reversion value.

* Appreciation or depreciation--the difference between the projected reversion and the current market value (via DCF analysis) on a present value basis.


Several examples of the unbundled cash flow analysis are illustrated here. The hypothetical examples are all based on the following set of base assumptions.

* 10-year holding period (reversion based on capitalizing year 11 net operation income)

* $20.00 per-square-foot, per-year market rent, with annual Consumer Price Index (CPI) escalations

* 10-year market lease terms

* 12-month downtime

* 50% renewal probability

* 5% per-year rent and expense growth

* 12% annual discount rate

* 9% reversionary capitalization rate

* 3% selling costs

For analysis purposes, the impact of loans and debt reduction has not been considered.

Example 1

The first scenario assumes a 15-year lease at market rent. Because the property is 100% leased for the entire holding period, there is no value attributed to the speculative releasing of the property. Over 50% of the value is derived from the annual cash flows resulting from the existing lease, while approximately 15% is accounted for by property appreciation. Figure 1 illustrates the breakdown of value components for this property.

In this example, the analyst and user may consider the reversion-before-appreciation component more secure than in a case in which the existing lease(s) of a property expires at or before the end of the assumed holding period. Because Example 1 assumes a 15-year lease, the reversion in year 10 would be based, in part, on income resulting from the last five years of the original lease.

Subject to a credit evaluation of the tenant, this income stream may be considered relatively secure, with the primary risk associated with the achievement of the 15% appreciation component.

Example 2

In contrast to Example 1, this scenario involves a property that is 100% vacant. No value is attributable to existing leases, while approximately 68% of the property value is accounted for by speculative leases and appreciation. Figure 2 shows the various value components and the percentage each contributes to value. This cash flow appears to represent increased risk compared with the cash flow in Example 1 because there are no existing leases. With such a large percentage of the value forecast from speculative leases and appreciation, certain investors and lenders may find this cash flow combination unacceptable in terms of the inherent dominant component risks.

Example 3

This scenario examines a property with a five-year lease term assuming the existing lease is at market levels. The unbundled cash flow attributes 36% of the value to existing leases, 13% to speculative leases, and 19% to appreciation. Figure 3 illustrates the value component breakdown. This cash flow scenario may represent a relatively balanced segregation of value. The analysis attributes 49% of value to existing and speculative leases and 51% to the reversion including appreciation. In light of the relatively equal proportions between leases and the reversion, this example may be considered risk balanced.

Example 4

This scenario assumes a five-year lease at one-half of market rent. The unbundled cash flow indicates that 17% of the value results from existing leases, 17% from speculative leases, and 34% from appreciation. In contrast to Example 3 (five-year lease at full market), a valuation of a property with a below-market lease attributes a much higher percentage of value to the speculative leases and appreciation components. The existing income component may be viewed as relatively secure based on the below-market characteristic. Figure 4 shows the results of the unbundled cash flow for this example. The analysis of a property with a five-year lease at a below-market rental rate attributes only 17% of current value to the existing lease, in contrast to 36% for this component in Example 3. A much greater percentage of value results from appreciation, which strongly suggests this cash flow may have more risk than the previous example.

Example 5

This example assumes a five-year lease at twice market rent. Because the cash flows in the initial years are much higher than those in the later years, the unbundled cash flow is heavily weighted toward existing leases (56%). Only 9% of value results from speculative leases, and 3% from appreciation. The disaggregated value components are illustrated in Figure 5. This example depicts that over half of the current value results from the existing lease. In comparison with Example 3, the percentage of value from existing leases increased from 36% to 56% as a result of the above-market lease. The evaluation of the credit rating of existing tenant(s) is crucial to the proper determination of the security of cash flow.


Risk-return analysis

The unbundled cash flow provides a tool for applying differing return requirements to the previously identified components of value. For instance, after careful examination, it may be concluded that existing leases represent less risk than speculative leases, appreciation/depreciation, or reversion before appreciation/depreciation. Thus, a discount rate lower than the overall yield rate may be appropriate. Higher discount rates may be applied to the other components. A blended discount rate may then be developed for the overall property.

The theory that each of the contributors to value may represent a unique risk level can be graphically illustrated, as shown in Figure 6. To illustrate this concept, Example 3 (five-year lease at market levels) has been recomputed with hypothetical discount rates. Table 1 summarizes the comparison between the usual discount-rate method and the unbundling method.

In this modified example, the overall property value and discount rate remain unchanged. The application of different discount rates to each component of value, however, results in a re-allocation of value to the individual elements, enabling analysts to more precisely rate different market risk factors. The percetage of value for existing leases and reversion before appreciation increased (because of lower discount rates), while the percentage of value for speculative leases and appreciation decreased (because of higher discount rates). Figure 7 graphically depicts these changes. [TABULAR DATA OMITTED]

Portfolio diversification and specialization

Portfolio investment strategy development may be enhanced by matching value components with risk expectations. The unbundled cash flow analysis provides an additional analytical tool for investors desiring specialized characteristics and enhances a portfolio manager's ability to analyze the effect of property aging on a portfolio. As property ages (i.e., moves along the income line), the allocation to each of the four value components is likely to change. Periodic analysis of a property may initiate a reconfiguration of assets in an existing portfolio. For instance, if Example 2 is in a portfolio, Example 1 may be added to counterbalance the investment risks. Figure 8 depicts such a combined portfolio stratification.


When an unbundling analysis is available, an appraiser is instantly provided the division of value components at the overall property discount rate. Appropriateness (i.e., comparability) of the concluded risk rates versus other income streams may be more readily evaluated through such a presentation. Valuation of individual components at varying rates of return provides appropriate and useful refinement to the analysis. Over time, application of varying rates of return to the individual value components should become an accepted and standard procedure, providing enhanced consistency to conclusions that involve similar property types and income characteristics.


An unbundling analysis better enables lending institutions to identify and measure the appropriate risks associated with contract versus speculative leases when evaluating value conclusions in relation to specific cash flow dollars and debt coverage ratios. As with portfolio management, lenders may attempt to balance underwriting risk in the total portfolio by assessing the various risks associated with the individual value components. Finally, when isolating the ultimate source of repayment for a loan, lenders can see graphically the comparison of the value-before-appreciation component (equity investment) and the appreciation/depreciation component. Again, such a comparison can assist a lender in assigning risk to the precise loan position and its corresponding collateral.


Investors benefit from an unbundling analysis's facilitation of a more efficient match between investment criteria and anticipated property level performance. In addition, portfolio combination and dissolution is expedited when the various components can be segmented.


When examining the graphically presented, unbundled cash flows, an analyst can readily review the components of value for a given property. Acceptable combinations of cash flows can be identified while unacceptable combinations can be discarded. The benefits of a visual representation are twofold: it will highlight those characteristics that present the optimal value combination at the anticipated risk rate, and it will identify those combinations that may require a risk adjustment.

(1.) See James D. Vernor, "Identifying Real Estate Investment Risk," The Appraisal Journal (April 1989): 266-270; Brian A. Chester, "Partitioning the Pre-Tax IRR," The Appraisal Journal (April 1986): 177-187.

(2.) D. Wylie Greig and Michael S. Young, "New Measures of Future Property Performance and Risk," Real Estate Review (Spring 1991): 17-25.

(3.) These include market rent, lease terms, rent and expense growth rates, renewal probability upon lease expiration, downtime between leasing if a tenant vacates, tenant improvements, and leasing commissions.
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

Article Details
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Author:Healy, John J., Jr.; Teetsel, Jeffrey
Publication:Appraisal Journal
Date:Jul 1, 1992
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