DCF vs. Direct Cap: How Close in Value?

[barcelona]

I am an appraiser trainee. I'd ask my boss this question (who is certified and MAI) but he is often too busy to answer. Not the greatest mentor.

We value a lot of large commercial properties (office, industrial, apartments) that are very high quality. Our primary mode of analysis is a 10 year DCF. However, we always also do a DIRECT CAP. He often tells me that, if done properly, these two market values should be relatively close in value (say within 2% of so). Is that % a common industry standard?

Are there any guidelines or regulations (USPAP, etc) that require the DCF and Direct Cap to be within a certain percentage of each other. Or is it just common sense that they should be close (or both)????

Thanks for any input.

 

[Pittsburgh Pete]

No guidelines, only common sense. The cap rate contains a multitude of assumptions/projections that mirror market activity (i.e yield rate, appreciation in income and/or overall property value, risk,etc.); likewise, a DCF attempts to capture these same assumptions/projections in a year by year analysis. What is happening to cash flow, property value,etc.? Stands to reason that the two methods should be relatively comparable to one another. Hiccups in cash flow that would be apparent in a DCF can cause the two to diverge more than one might expect (i.e. large quantitites of leases coming due at the same time in a soft market where releasing may be an issue). If they diverge significantly, one has to ask himself why.

 

[PL1957]

The only difference between the Direct Cap and a DCF is that the assumptions in a DCF are explicit while the assumptions in a Direct Cap are implicit. If you are doing it right, there should be minimal difference.

 

[John Glass]

Correct me if I am wrong. Don't bother with a DCF on an apartment. The leases are short term, a year or less and assumed to be generally at market rates. At least according to the Appriasal Institute. No one has ever asked for a DCF on an apartment from me.

Nothing specific requires a DCF only that your scope of work be complete. A client might specify a DCF, as a supplimental standard.

 

[C. Kevin Bokoske MAI]

If you used Direct Cap, with an overall or going-in cap rate of say, 8%, and capped the NOI, you would get a value indication. If you took the same PGI, vac, EGI, OE, and grew them by the same constant rate, say 2% annually, the NOI would also increase by a constant rate of 2% during the holding period. If you used zero selling costs at the reversion, used the same 8% cap rate as your going out cap rate, you would arrive at exactly the same indicated value if you discounted the cash flows and the reversion in the final year by 10%. Ro + CR = Yo. It works!

Kevin

 

[George Hatch]

I've used this as a reality check in the past and - if all the other factors basically mirror the rate of change in the income - have found the results to be generally consistent with the data indicated in the market. The cost of sales and possibly a different terminal cap rate for the reversion in the DCF seems to be the main difference.

Of course, I think that if the market participants are primarily relying on a GIM or Direct Cap and there's nothing unusual about the income stream it's probably more direct to use the methodology actually used in the market. DCFs look cool and they intimidate most of the casual readers but with more variables they are more susceptible to error via unreasonable assumption.

 

[Vernon Martin]

These are all good comments. If one reads about the history of DCF analysis, it became famous in the analysis of the Pan Am building in New York (now the Met Life building). This was around 1980, when personal computers started to be used for financial analysis.

The circumstances were unique, as the financial industry in Manhattan was experiencing a blossoming of innovation at a time when the country's office market had been stagnating in an "economic malaise' (as defined by Jimmy Carter). If you look at office districts throughout the US, you will typically see no buildings constructed between 1975and 1980. In 1979 and 1980, though, office space in Manhattan was being rapidly absorbed and asking rents increased 50% in less than two years.

Appraisers using direct capitalization based on the rates of the 1970s were missing out on a market that was taking off. The buyers of the Pan Am Building used a lease-by-lease DCF model to justify their purchase decision at the time, which equated to a going-in cap rate of about 4%. The high valuation was based on rapidly increasing rental rates.

Then, the country became high on DCF analysis, and all sorts of crazy things happened.
It ended up getting a bad rap, and I see it used less nowadays than back in the 1980s.

 

[PropertyEconomics]

If you used Direct Cap, with an overall or going-in cap rate of say, 8%, and capped the NOI, you would get a value indication. If you took the same PGI, vac, EGI, OE, and grew them by the same constant rate, say 2% annually, the NOI would also increase by a constant rate of 2% during the holding period. If you used zero selling costs at the reversion, used the same 8% cap rate as your going out cap rate, you would arrive at exactly the same indicated value if you discounted the cash flows and the reversion in the final year by 10%. Ro + CR = Yo. It works!

Kevin

Only problem I see Kevin .. is that in my market expenses increase while rents have remained flat or have decreased slightly. While it certainly works on paper, Im not so sure it works in reality in quite the same way.
One must know their market trends in order to properly forecast rents / expenses over the projection / DCF period. Similarly, 10 years out, the reversionary cap rate, in this environment, may well be a guess at best.

Very interesting history lesson Vernon .. thanks.

 

[BobfromSalem]

Right on, Vernon.....Much of my work in the late 80's, early 90's was cash flow intensive.....After awhile, I found that too much of the appraisal process was dependent on some software package. Nowadays, I do alot more direct Cap stuff on smaller properties....I enjoy it more-- now more time is spent on appraisal logic, rather than reading and inputting tenant leases.

 

[GCJim]

Vernon, thanks for the history! Very interesting stuff. I knew that the DCF method had fallen in and out of favor, but I never knew the background and justification.
As far as predicting cash flows and reversion in this kind of a market, I would be extremely nervous, to the point of ulcers, methinks!