Morgan Stanley: Everything is a DCF

It’s official: gone are the good old days of all-risk-yield-driven Investment Valuations satisfying best-in-class practices as a primary methodology. While experienced dealmakers know when they see a good deal, best-in-class investors require due diligence (‘DD’) to back-up any deal instincts or implicitly mysterious arguments for a quick desktop valuation.

Since the 1990s this DD workload has only become more layered/complex, time-consuming, and costly for businesses. To add to that talent inflation is on the rise. But there is no going back. Most international institutions allocating money to global gateway cities like London and New York demand Discounted Cash Flows (‘DCFs’) – to satisfy rigorous processes, investor questionnaires and higher degrees of financial scrutiny. Back-of-the-fag-packet math no longer cuts the mustard.

Unfortunately teams without good software & human processes tragically reduce otherwise top deal-making instincts into an institutional drip of ‘paralysis by analysis’

Unfortunately businesses without good software & human processes, tragically reduce their deal instincts into an institutional drip of ‘paralysis by analysis’. Better teams eat their lunch by efficiently filtering new deals for their fund strategies. This also has an internal detrimental impact on staff motivation and retention. We regularly hear stories of chronic and risky methods: down to granular copy-&-paste activity between blackbox appraisal software (e.g. Argus Enterprise or MRI Software) over to butchered legacy spreadsheets to complete a Board report task.

Morgan Stanley’s recent paper “Everything is a DCF Model” explains why DCF models are important not just for valuing commercial real estate but for all cash-generating assets. It warns those professionals who tend to consider them “quaint” exercises as many remain in awe of skyrocketing valuations across many fields, not least of all technology.

Morgan Stanley’s recent paper “Everything is a DCF Model” explains why DCF models are important for valuing all cash-generating assets.

Morgan Stanley, “Everything is a DCF Model”, Q3 2021

The discipline of DCFs -i.e. to be explicit about each income and expense line over time- makes them the primary tool for best-in-class advisors, investors and lenders. Just as penning an essay brings clarity of thought to each writer, converting a business proposal into an explicit DCF reveals the inescapable dynamics of investment scenarios. Many of which are impossible to document from highly-generalised human instinctive opinions.

Not only is there a demand factor today driving the need for DCFs. There is also a supply-like tension thanks to the sheer changing structure of the real estate market:

The leasing tech community often talks about how 25-year leases are a thing of the past…i.e. how Landlords need a customer-centric outlook, and how tenants benefit from shorter terms, flex space, hybrid working options, etc. While this phenomenon is very important for the leasing brokerage industry, there is also a DCF consequence for the Capital Markets side of the real estate industry:

From an all-risk-yield perspective: 25-year leases were easier long income to value implicitly with a yield-driven opinion from a traditional RICS valuer. Shorter lease patterns and greater tenant flexibility generate more complex income & expense patterns. As night follows day, DCFs are the best methodology to work through this reality on a deal-by-deal basis.

Professionals that have been in the real estate investment business for a decade or two will have come across valuation professionals that can wax lyrical about their implicit valuation methodology, and how it is essential in order to bring into play investment comparables (‘the comps’). An entire methodology and fee-earning industry has been built upon this implicit approach.

The Global Real Estate industry is not alone in how it has shirked away from fully embracing Discounted Cash Flows as a primary methodology. The Morgan Stanley paper spells out the various arguments all professions must occasionally rehearse to themselves for the sound and proper financial reporting of cash-generating assets.

In terms of the property sector, it is a mark of great progress to see that the January 2022 RICS Investment Valuation Report moves the industry forwards. All global surveyors must now embrace DCFs as the primary methodology for Investment Valuations.

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