This Dashflow article first appeared on REACT News (28/11/23).
Mike Molloy, Dashflow for CRE.
It’s been nearly two years since the RICS Investment Valuation Review report seemed to usher in a new era of discounted cashflow-orientated valuations. Led by Peter Pereira-Gray and assisted by a host of industry experts, the report sought to establish the “primacy of discounted cashflows” for investment valuation purposes.
Fast forward to earlier this month when in anticipation of a Global Red Book update in 2024, and following its Review of Real Estate Investment Valuations, the RICS released new guidance for using the method of discounted cashflows (DCFs) in the valuation industry.
The announcement made it immediately clear that Pereira-Gray’s brave new world is going to be optional: “The new practice information does not impose specific requirements to use the methodology. While RICS encourages DCF use where suitable, it is committed to the valuer’s autonomy when selecting an appropriate valuation method, or methods and models.”
Leaving aside for a moment the question as to who signed off on this change of tack, the new guidelines have been shaped by the most traditional of English valuation academic mindsets. Commercial direction is missing. Not only do they confuse and obfuscate real world investment valuation work, the latest guidelines will exacerbate the very issues that the Pereira-Gray report was tasked with addressing.
“More like sabotage”
The implementation of the DCF recommendations via these guidelines is more like sabotage. The primacy of DCFs in investment valuation has been turned on its head by the very guidelines that should enforce the recommendations, and which were publicly approved by the governing body of the RICS without any reservations.
There are several points where the new guidance differs from the review’s original recommendations:
- Importance of DCF in valuation: The independent review emphasised more weight should be attributed to the DCF method for its ability to reflect anticipated market changes and for being a forward-looking approach. In contrast, the latest guidance document, while acknowledging the use of DCF, does not explicitly advocate for its increased adoption or emphasise its forward-looking nature as strongly or indeed in the practice examples given.
- Adoption across different regions: The independent review notes that DCF has been the standard in the US and mainland Europe for more than 30 years. The guidance document does not specifically address any regional differences or implications for the disciplined and robust adoption of DCF methods.
- Prescriptive guidelines on DCF: The independent review suggests that there is a call for more prescriptive guidelines on the application of DCF models. The guidance document appears to shy away from any prescription. Only a general approach is provided. More text is dedicated to protecting the existing valuer’s choice and responsibility to select an appropriate method. There is no strong emphasis on prescribing DCF over other methods. There is no primacy of DCFs – not even for the most obvious use cases of institutional multi-let complex investments. “Major shopping malls” are simply lumped together with “single-occupier residential investment property” without any discerning guidance.
- Application of DCF in the UK market: The independent review talks of a move towards DCF in the UK, moving away from the traditional UK-centric yield basis of valuation. The guidance document does not make a clear recommendation for this move, instead describing the contextual use of DCF and its reconciliation with other valuation methods like the implicit income capitalisation method.
Shortcuts in any context can be seductive. In valuations, they are very useful for timely and early investment discussions. However, many valuers rightly sniff with concern at the meaning of “desktop vals” used between investment brokers. Valuers will be concerned about any shortcuts that may trample on their hard-earned discipline of being a qualified valuation professional. It is then quite shocking to see the guidelines currently promoting a “short-cut DCF”.
No quick fix
During 15 years of cashflow responsibilities for the likes of Rockspring and Deutsche Bank, and having seen billions of pounds of acquisition models authored by global capital players, I have never seen the “short-cut DCF” widely used in finance within a customer-facing investment valuation context. The choice of a “short-cut DCF” name is also completely misleading, as it probably looks nothing like a DCF to most clients who see the real thing on a daily basis.
Real DCFs are about far more than the applied discount rate. They instil transparency, legibility, robustness and trust.
These guidelines effectively translate into: feel free to use whatever method you want, whenever you want. They betray the original purpose of the Independent Valuation Review and are a major disservice to the surveying profession, which is already experiencing a crossroads moment in terms maintaining relevance and effectiveness.
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This RICS issued a rebuttal article which first appeared on REACT News (04/12/23) and you can read here.
RICS defends approach to discounted cashflow valuation
The new Global Red Book update in 2024 provides a good balance between the use of DCF and other more traditional valuation methods suited to the market place – and calculating Fair Value or Market Value – please note the RICS definition. DCF is just one tool – and not necessarily the best tool for these assessments! Delighted the RICS has seen sense and not followed the crass and ill informed initial comments on valuation! Well done RICS!