DCF or Direct Cap

[Terrel L. Shields]

We guess about the condition of our comps, whats so bad about guessing about the effective age assuming that "guess" is based upon market extracted effective ages? That is no guess. Using Total Life tables from M & S or residual tables from Boeckh is no "guess." And, yes, after experience we should be able to estimate effective ages rather closely without making undo reference to grids created for individual properties.

Some 5 yr old residential properties in some small subdivisions around here are selling for $60/SF and new houses in the same subs are being built for $65/SF. So calculate it yourself, and if you do the Cost Approach in those subs will be extremely close to the Sales Approach and just as likely an indicator of future sales price.

After a house gets 10 years old the picture complicates because about one-half those houses are going to be a significant make over before turning 20. again, if our comparable sales info is complete, we should be able to make reasonable adjustments for effective age.

 

[slacker]

Pat and Steve,

When do you guys have any time to practice what you preach? I thought everyone was real busy with refi’s these days. From what I have read, the two of you were going back and forth for 5 hours on Thursday and from 8:00 am to 4:23 pm on Friday.

Must be nice to have all that free time. Can’t you guys settle this over a “Pint”? Or maybe a little arm wrestling would be good?

Oh, and from what I’ve read I bet Steve’s Dad can beat up Pat’s Dad. At least that’s what I thought I was going to read next…….

Now put down your keyboards, get out there, do some appraising, and make some money!!!

 

[Stephen J. Vertin MAI]

This is the first time I have participated on the commercial forum. Pretty neat, pretty neat. Steve at first your question does appear trick. Paul is correct in stating by definition Ellwood is direct capitalization. In fact any method used to convert an estimated single year's income into an indication of value using the appropriate income factors is considered direct capitalization.

However, if a DCF's assumptions are the same as Ellwood the answer, using either method would be equal. I have heard it said Ellwood is basically a DCF under its defined assumptions of cash flow and value escalations/declines. However, that could be said about any direct method and I think it was used by instructors as more of an example of the mechanics of Ellwood. But by definitions Ellwood is considered direct capitalization. A better question, for all practical purposes, is "Who uses Ellwood and why?"


Steve Vertin

 

[Paul Ness MAI]

Your last question is a good one. In the few reports I have seen with Ellwood, it is abused and the result is a low cap rate. I believe in some cases I have seen, that it is used to produce such a result and give the appearance of a more sophisticated analysis that just snows the typical appraisal user.

 

[George Hatch]

I used to use Ellwood all the time, but now I just stick to using a simple buildup. Besides, better to extract the Ro data from the sales when it's available.

I also used to do DCFs all the time, too. Now I only use one if the income stream isn't stable during the holding term. You know, lease rates are changing or big expense items are looming. I still do DCFs for all long term land leases and franchises, even though I've been told that the investors only use direct cap and almost never use DCFs. I have been doing the direct cap with bonus rent and/or rent loss calculations a lot more lately. I think I prefer that approach the best for small stuff.


George Hatch

 

[Tom Hildebrandt]

It is an interesting perspective to come back after three months of no appraising, and see these kinds of discussions.

I can not say I missed the name calling and mudslinging, but I like the acedemic and intelectual intensity of the discussions, and missed that while sailing.

My cut on this thread is that the DCF verse Direct Cap is a largely moot point. By definition, a single years income converted to a value is direct cap, but as one poster noted, the underlying intent of the Elwood stuff was to provide a solution to varying income streams in a pre PC world using a simple alegbraic method. If the assumptions are similar, the end results should be similar. If not the mathemeticians need to rethink the underlying math principles.

But the deeper issue I note is that there appears to be some misunderstanding of what we as appraisers are doing. We express opinions - ideas or beliefs which can not be proved but are held with conviction. USPAP and our practice requires that we not make unsupported assumptions and that we must have a reasonable basis for them. Just because we can not prove the the assumption to be 100% true all the time, (it would then be fact and not opinion) does not mean the assumption, is right or wrong, just that it is supportable. This is why two appraisers can disagree on an item as the effective age of an 100 year old residence.

The same is true about methods and techniques. Whether a technique should be generally accepted or even its appropriateness in a specific scenario is always a subjective opinion. The issue that is not truly definable is whether a specific solution is reasonable in the context of a specific appraisal application.

Having said that, I commend the posters for an interesting acedemic and theoretical discussion, just stay away from the name calling.

Best regards

Tom Hildebrandt GAA

 

[Terrel L. Shields]

Tom said

our practice requires that we not make unsupported assumptions and that we must have a reasonable basis for them.

Right-o. Income property, ie. commercial, imho, seems to be less sophisticated that we often treat it. Even some very expensive income properties like carwashes, conv. stores, liquor stores, storage buildings, quicklubes, etc. are generally bought on the basis of gross income or sales. Often the owner is skimming the take, overstating the expenses when possible, and in general, getting dependable income info for many owner operated businesses is dang near impossible.

Underappraising runs the risk of merely appraising the liquidation value, i.e. - land plus building as though it were vacant. Overappraising often results when the owners numbers are "cooked." and we run the risk of mixing business value and real value when a bank often asks for "market value" without a real distinction of what they want.

I find buyers want to know what the gross is. Thus a GIM calculation may be the best indicator of value. In the Rule of Thumb world that might be called Years to Payout instead of GIM. Often I find a 3 - 5 to 1 ratio is applicable for owner operated businesses.

More sophisticated analysis may be applicable to rentals, such as motels, apartments, etc. but mom & pop shops, small oil and gas interests, etc. are appraised by GIMs.

I have a tendency to rely upon the cost approach as a way to bracket the probable value. A location has to be extremely unique, (such as, in front of the SuperCenter or only vendor in the State park) for cost of land plus building contribution to not be a cap of the value, otherwise go somewhere and build one just like it.

 

[Stephen J. Vertin MAI]

Tom:

Welcome back, I was thinking about you last week. I thought it was around the time for your return. George, no shame in using Ellwood, especially in the past. It is just that DCFs are more efficient given spread sheet programs now available. Furthermore, DCFs are easier to follow. Terrel, I would agree that are a number of property types where it is near impossible to distinguish business value from market value, even though many appraisers try. Steve, I for one am interested in hearing more about the court case you are talking about. Could you please share more details on the case?


Steve Vertin

 

[Paul Ness MAI]

Terrel, good post. It pretty much reflects my view of discerning levels of analysis in the income approach. I have always taught that we are emulating the market and our analysis should be at a level commensurate with a typical buyer. The only thing I might take issue with is your use of the GIM. I don't find too many investors in my market making purchase decisions based on GIM without careful examination of lease terms and expense ratios, which brings you back to NOI.

 

[Fred]

Steve,
I will give you the readers digest version of the case if you send me a private message.

Tom,
I agree about intellectual and academic discourse. I slung some of that mud after running out of other cheeks.

On your point that the difference between DCF and Direct Cap being moot-
I would refer you to SMT-2 of USPAP. Parts of which, state:
"Discounted Cash Flow is an accepted analytical tool and method of valuation within the income approach…
DCF analysis is an additional tool available to the appraiser and is best applied to value estimates in the context of other approaches…
This statement focuses on the criteria for proper DCF analysis and does not imply that DCF analysis is or should be the only method employed"

I may have neglected to mention that my post was in reference to an apartment appraisal where DCF is the only method used.