Understanding & Testing DCF Valuation Models

Understanding and Testing DCF Valuation Models TR-33

Understanding & Testing

DCF Valuation Models

The Appraisal Institute

Larry T. Wright, MAI, SRA Instructor

[email protected]


Announcements

Restroom locations

Smoking areas

Be considerate of those near you

Turn off cell phones

Attendance sheet

Certificates and evaluation forms

Break times and lunch

Intro


Fee Simple v. Lease Fee

This seminar deals with the leased fee

interest. However all of the tests cited can

be used to test and understand fee simple

DCF analysis.

Intro


Model Sensitivity, Part 1

Revenue

Vacancy

Expenses

Rates

Construction

Reversion

Part 1


Part 1. Model Sensitivity

Low sensitivity is a nonmaterial change

in results < 2%

Moderate sensitivity is a material, but

not a significant change is results and

quantified as > 2% but < 5%.

High sensitivity is a material and

significant change quantified as >= 5%

Part 1, page 3


Part 1 Model Sensitivity Revenue – Leased Fee

A. Market Rent – Properties with seasoned

rent rolls are highly sensitive to changes in

market rent.

B. Market rent growth – Sensitivity of DCF

results to changes in the market rent growth

rate is similar to the sensitivity changes to

changes in market rent. This is boosted in

combination with high numbers of lease

expirations.

Part 1, page 3


Part 1 Model Sensitivity

Revenue – Leased Fee

C. Tenant reimbursement of expenses – The

impact in reimbursement levels is dramatic.

Variations in the expense recapture rate

directly affect net operating income and are

not offset by lease rates and expirations.

Part 1, page 3


Part 1 Model Sensitivity Vacancy and collection loss

A. Vacancy – Modest changes in stabilized

occupancy have a low impact on results

1. Absorption, anticipated lease expirations,

and lag vacancy projections can overshadow

the impact of changes in general vacancy.

2. In property types with relatively high

fixed operating expense ratios moderate

increases in occupancy significantly increase

net income

Part 1, page 3


Part 1 Model Sensitivity Vacancy and collection loss

B. Collection loss – Variations in the collection loss

estimate produce the same type of changes as

variations in the vacancy estimate.

C. Rollover/Renewal sensitivity – The tenant retention

probability typically governs downtime between

leases, tenant improvements, and leasing

commissions. Depending on the frequency and size

of the lease expirations, alterations in renewal

probability can have a significant effect on results.

Part 1, page 4


Part 1 Model Sensitivity Expenses

A. Operating expenses – The impact of changes in

operating expenses is significantly dependent upon

expense recapture arrangements.

1. In cases where tenants reimburse all or most of

the expenses, results are only nominally sensitive to

expenses.

2. In cases where expenses are split between the

tenant and landlord, even modest changes in

expenses can have a significant impact on results.

Part 1, page 4


Part 1 Model Sensitivity Expenses

3. The higher the operating expense rate, the greater the impact of changes in expenses.

B. Expense growth rate – Like operating expense amounts, the effects of expense growth rates are significantly dependent upon expense recapture arrangements.

C. Tenant improvement (TI) sensitivity – The impact of changes in tenant improvements is typically low, but it is dependent upon the cost of tenant improvements. Properties with a high frequency of lease expirations can be more significantly affected by tenant improvements.

Part 1, page 4


Part 1 Model Sensitivity Rates

A. Discount rate – A change in the discount

rate is proportionally reflected in the result.

The effect of a 25 or 50 basis point change is

low.

B. Terminal capitalization rate – the effect of a

25 to 50 basis point change is moderate in a 10

year holding period.

Shorter holding periods are more sensitive to

changes in the terminal cap rate.

Part 1, page 4


Part 1 Model SensitivityModel construction

A. Fiscal or annual accounting – The selection of fiscal or annual year accounting has a low impact on results.

B. Holding period – Proper selection of the expected holding period can cause results to vary by significant amounts. The inclusion or exclusion of years with signifcant variations in net cash flow has a high impact upon the value.

Part 1, page 5


Part 1 Model SensitivityModel construction

C. Discounting period – The use of

shorter discounting period (less than one

year) can have a low impact on DCF

reults.

Part 1, page 5


Part 1 Model Sensitivity Reversion

A. Reversion year – The reversion year is determined by the selected holding period. If the holding period is not appropriate for a reasonable estimate, then the outcome can be materially affected.

B. Cost of resale – Variations in property disposal costs at the end of the holding period have a low impact on DCF results.

Part 1, page 5


Part 1 Model Sensitivity Let’s try out some of these assumptions.

DCF example (fee simple)

Part 1, page 6 - 7

Understanding and Testing DCFs Spreadsheets.xls


Model Sensitivity, Part 1

LOW

Vacancy

Collection Loss

TI

Commissions

Construction

Reversion Year

Cost of Resale

MEDIUM

Cap Rate

Inflation

Exp. Growth

HIGH

Rent

Discount Rate

Exp. Estimate

Rent Growth

Reimb. Rate

Part 1, page 8


Part 2. Tests of Reason

Input

Math

Rental Revenue

Reimbursements

Occupancy

Expenses

Reversion

Analysis Assumptions

Event Auditing

Change Patterns

Rates

Balance

Results


Input Checks

Credible Analysis

Leases

Occupancy

Reimbursements

Expenses

Base Year

Part 2, page 9


Math Review

Accurate Calculations

Reliable Software

Part 2, page 10

Understanding and Testing DCFs Spreadsheets.xls


Revenue Tests

Arm's-length Leases

Market Rent & Contract Rent

Tenant Improvements

Income Growth Rates

Tenant & Income Concentration

Part 2, page 11


Part 2, page 12


Comparison of Market Rent

and Contract RentYear 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11

Contract Rent $23.47 $23.59 $23.58 $24.99 $25.02 $27.85 $29.90 $31.04 $31.33 $31.45 $31.06

Market Rent $25.40 $26.16 $26.95 $27.76 $28.59 $29.45 $30.33 $31.24 $32.18 $33.14 $34.14

Ratio 92.4% 90.2% 87.5% 90.0% 87.5% 94.6% 98.6% 99.4% 97.4% 94.9% 91.0%

Holding Period 93.3%

Average

Part 2, page 13


Revenue/Expenditures

Tenant Improvements should be

reasonable based on market conditions,

rent projections, and lease terms.

Rent growth/inflation rates / forecasts –

such as rent spikes and rent of increase

should be carefully evaluated in relation

to investor expectations, market

conditions, and property characteristics.

Part 2, page 14


Revenue/Expenditures

Market growth should be consistent

with market analysis. Oversupply

conditions are inconsistent with

increasing rents.

Compare rental rates with feasibility

rents, if above then rents cannot be

maintained.

Part 2, page 14


Tenant concentration

If a large portion of occupancy or

income is concentrated in a single tenant,

the quality of that tenant and the terms of

the lease are important factors in rating

the risk in the cash flow and selecting the

appropriate discount rate.

Part 2, page 14



1. Determine percentage of the total rentable area each tenant occupies.

2. Determine the percentage of total income each tenant contributes.

Closely examine the major tenants contract rent, reimbursements, renewal probability, tenant improvements, and leasing commissions.

Part 2, page 14



3. Credit tenant impact – Determine how

much of the property is occupied by

credit tenants and how much income is

contributed by credit tenants. A high

percentage of occupancy and income by

credit tenants indicates a lower risk

profile for the property.

Part 2, page 14



Part 2, page 15


Reimbursements

Expense Recapture

$

Part 2, page 16


Reimbursements

A. Trends in the percentage of operating expenses over the holding period can be examined to check for changes in the operational performance of the property.

B. If high percentage of expenses are recaptured the importance of the expense projections can diminish because the property owner does not pay them.***

***This assumes the tenant can afford to pay the pass through expenses.

Part 2, page 16


Reimbursements

C. When more than 100% of expenses are

collected the expense growth rate

becomes a factor of income growth.

D. In some case, recaptured operating

expenses can exceed actual operating

expenses. This could be due to efficient

property management, expense

reimbursement surcharges, or the result

of errors in the DCF.

Part 2, page 16


Expense Recapture Chart

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11

Tenant reimburse- $496,577 $506,539 $554,020 $586,556 $601,827 $589,984 $597,104 $605,343 $609,237 $646,069 $668,735

ment revenue

Operating Expenses $665,824 $693,351 $732,186 $762,739 $797,118 $830,213 $874,232 $920,535 $959,372 $1,005,530 $1,051,106

Expense Recapture 74.6% 73.1% 75.7% 76.9% 75.5% 71.1% 68.3% 65.8% 63.5% 64.3% 63.6%

Holding Period Average 70.9%

Part 2, page 17


Expense Recapture Graph

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 1

0

Year 1

1

Expense Recapture

Holding Period Average

Part 2, page 18


Occupancy

Vacancy & Collection Loss

Vacancy Evaluation

Lease Expirations

Rollover

Office Space

For Lease

Part 2, page 19


Occupancy

A. Vacancy and collection loss – Evaluation of vacancy must be in terms of market and property expectations for tenant absences.

1. Two primary approaches modeling that can used alone or in combination.

a. General or overall vacancy applies a stabilized rate to the income.

b. Absorption and turnover replicate changes in the tenant base.

2. Collection loss is dictated by tenant credit and industry risk

Part 2, page 19


OccupancyB. Vacancy evaluation:

1. General vacancy projections should be compared to actual vacancy as created in the DCF model.

2. Projected vacancy can be compared to historical occupancy at the subject, current occupancy, market occupancy, and stabilized market occupancy.

3. Appraisers should check the occupied building area in each year of DCF to insure that the property is not being overfilled or over rented.

Part 2, page 19


Vacancy Chart


Rentable area (SF) 101,500 101,500 101,500 101,500 101,500 101,500 101,500 101,500 101,500 101,500 101,500

Stabilized occupancy 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0%

Average Occupancy (SF) 68,926 91,927 101,271 101,119 100,255 98,787 98,344 100,276 100,510 100,869 97,791

Average Occupancy (%) 67.9% 90.6% 99.8% 99.6% 98.8% 97.3% 96.9% 98.8% 99.0% 99.4% 96.3%

Hold Period average 94.8%

Part 2, page 20


Vacancy Graph

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%Y

ea

r 1

Ye

ar

2

Ye

ar

3

Ye

ar

4

Ye

ar

5

Ye

ar

6

Ye

ar

7

Ye

ar

8

Ye

ar

9

Ye

ar

10

Ye

ar

11

Average Occupancy

(%)

Stabilized Occupancy

Part 2, page 21


Lease Expiration ScheduleC. Lease expirations for each year in the holding

period will recognize the years in the DCF analysis that are subject to rollover risk and lease-up costs. Lease expirations should be considered in the risk analysis and reversion year selection.

1. Should match lease expirations

2. Determination of average remaining lease term can assist in evaluating risk.3. Renewal rate for option terms compared with market rents

Part 2, page 22


Lease Expiration Schedule

D. Rollover vacancy, turnover or lag vacancy, is vacancy that occurs between lease expiration and the releasing of the vacancy.

1. Can be calculated based on occupancy or income reports.

2.Rollover vacancy can be approximated from the rollover probability, rollover vacancy in months and the new lease term in months.

Part 2, page 22


Lease Expiration Chart


Rentable Area (SF) 101,500 101,500 101,500 101,500 101,500 101,500 101,500 101,500 101,500 101,500 101,500

Lease Expiration (SF) 44,265 7,834 14,625 4,576 15,444 44,419 26,012 27,569 0 8,076 44,501

Lease Expiration (%) 43.6% 7.7% 14.4% 4.5% 15.2% 43.8% 25.6% 27.2% 0.0% 8.0% 43.8%

Holding Period Average 19.0%

Part 2, page 23


Lease Expiration Graph

Part 2, page 24

Lease Expiration (%)

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

Year

1

Year

2

Year

3

Year

4

Year

5

Year

6

Year

7

Year

8

Year

9

Year

10

Year

11


Remaining Lease Terms

Part 2, page 25


Remaining Lease Term3. Renewal probability evaluation should

be made with considerations for rental

levels and effective rent. Aggressive

rental rates and effective rents are more

likely to be associated with lower tenant

retention rates.

4. Rollover vacancy should be market

supported.

Part 2, page 25


Expenses

Adequacy of Amounts

Growth Rates

Operating Expense Ratio


ExpensesA. Operating expenses – projections must

be sufficient to maintain the property.

The age and condition of the property

should be considered.

B. Non-operating expenses – such as

reserves, leasing commissions, tenant

improvements, and capital expenditures

have a dramatic impact on DCF results.

Part 2, page 26


ExpensesExample – Preserving the Property’s Position

A 12 year old Class A property will be 22 years

old at the end of a 10 year holding period.

Sufficient amounts need to be expensed to

insure that the property will be positioned to

compete in the Class A market place for

tenants and investors. Insufficient expenditures

will result in a lower terminal value and

increased risk during the holding period.

Part 2, page 26


ExpensesC. Expense growth rates should be based on

investor expectation, inflation, expense trends,

and property condition/age.

D. Operating expense ratio (OER)

1. First year consistent with norms for the

property type and market.

2. Trends in OER should be checked for

changes in operational performance. OER

usually increases as a property ages.

Part 2, page 26




Effective Gross Income (EGI) $832,802 $840,739 $882,678 $926,709 $972,939 $1,021,482 $1,072,443 $1,125,954 $1,182,132 $1,241,120 $1,303,052

Operating Expenses $403,720 $423,517 $444,210 $465,940 $488,203 $511,550 $536,033 $561,707 $588,633 $616,865 $646,477

Operating expense ratio (OER) 48.5% 50.4% 50.3% 50.3% 50.2% 50.1% 50.0% 49.9% 49.8% 49.7% 49.6%

Holding period average 49.9%

Part 2, page 27



47.5%

48.0%

48.5%

49.0%

49.5%

50.0%

50.5%

51.0%

1 2 3 4 5 6 7 8 9 10 11

Operating Expense

Ratio (OER)

Holding period

average

Part 2, page 28


Reversion

Methodology

Reversion Year Selection

Normalcy

Part 2, page 28


Reversion Year Testing

Part 2, page 29


Analysis Assumptions

Projection Period

Fiscal/Calendar

Discounting Period

Cost of Sale

Negative Cash Flows

Part 2, page 30


Event Auditing

Occupancy Trends

NOI & Cash Flow

Leasing Expenses

$0 $500,000 $1,000,000 $1,500,000 $2,000,000

Year 1

Year 2

Year 3

Year 4

Year 5

Part 2, page 31


Occupancy

Part 2, page 32


Net Income and Cash Flow

The relationship between NOI and cash

flow can be illustrated graphically.

Part 2, page 33


Change Patterns

Pace of Change & Pattern

Expenses

Income

Cash Flow

NOI

Appreciation

Part 2, page 34


Growth Pattern Calculations

and Graphs

Part 2, page 34


Growth Pattern Graphs

Part 2, page 38


Determining Change Rates

Chart and Graph

Part 2, page 39


Determining Change Rates

Graph

Part 2, page 41


Expense Change Rate

Part 2, page 42


Change Rate Analysis1. Income change pattern should be consistent

with market expectations of rent growth and

general inflation.

2. Expenses change rate should be consistent with

general inflation, individual and total change

rates.

3. NOI change pattern should be consistent with

income growth and market expectations. NOI

is important in evaluating the implied going-in

capitalization rate.

Part 2, page 43


Change Rate Analysis4. NCF is subject to the greatest variation

and least consistency with other elements.

5. Appreciation/depreciation should be

consistent with market expectations.

Change rate comparison should contrast

the income changes and the expense

changes.

Part 2, page 43


Change Rate Comparisons

Part 2, page 44


Rates

RT

IRRRO%

%%

%

YO

Part 2, page 44


Balance

Cash Flow

Conservative

Reversion

Optimistic

Part 2, page 46


Input Assessment Testing

Part 2, page 48


Results

Common Sense/Experience

Sales

Multipliers

Debt Coverage Ratio

Part 2, page 49


Tests of Reason Case Study

Property – Steven Building

Class A Suburban, multitenant office

building

75,000 square feet of net rentable area

Occupancy is 100% with 3 tenants.

Documents

Understanding & Testing DCF Valuation Models