We all know that “Cash is King”. It therefore comes as no surprise that real estate financial analysis in our generation and longer have virtually all focused on cash flows, discounted cash flows (DCF) and net present values (NPV). In fact, the DCF methodology was first articulated in 1938 by John Burr Williams in his article “The Theory of Investment Value”. Having been around so long and having been utilized so often, how is that so many decision makers have lost so much money so often?
The absolute and unquestioning reliance on DCF will lead to poor decision making which will ultimately destroy value as opposed to its oft stated objective of value creation. Prior to recommending and/or making any final decisions the decision-maker and Board of Directors, where applicable, needs to perform its own due diligence on the DCF analysis presented to them. What follows is a brief overview of the bumps and potholes that one needs to be cognizant of, and what decision-makers need to be keenly aware of under the heading of “Decision-Makers Beware”.
The Discount Rate
Perhaps one of the most glossed-over variables in any DCF analysis is the Discount Rate. Usually a firm’s weighted average cost of capital has been used as a proxy for the Discount Rate. However, it should not be that simple. In its essence the Discount Rate needs to be a measure of risk and risk is multi-dimensional. Risk is not static and the Discount Rate should not be static – it needs to reflect the nature of the risks inherent in a particular project as well as the alternative strategies that will be examined. Here are only a few of the questions that the selection of a Discount Rate needs to take into consideration:
- How easily, how accurately and to what degree of reliability can the cash flows in fact be projected?
- How far out in the future are the cash flows being projected? Should you use the same Discount Rate for projecting cash flows for the next 5 years as you would for years 16 to 20 in the analysis?
- How are you financing the project? Only rarely does the use of debt/leverage create economic value. Yes, financing with debt can improve your cash flows but debt financing also increases risk (default risk, refinancing risk, interest rate risk, etc.) so at the end of the day, the Discount Rate needs to be appropriately adjusted based on how the project is expected to be financed.
- What can go wrong – what is the relative volatility of the cash flows associated with each of the strategies? Watch your assumptions and build the model assuming that on occasion the worst may indeed happen.
Bottom Line: Choosing the appropriate Discount Rate is an Art not a Science, and Art is in the eye of the beholder. What should you do? Perform sensitivity analysis testing using different Discount Rates to better understand the results and how value is created. Then, you can risk weight the sensitivity testing results using probabilities. Will the final analysis be 100% accurate? Definitely not. But asking the right questions will lead to a better understanding of the alternatives.
The Status Quo
Many project analyses compare alternative strategies to the “Status Quo” and measure the differential impact in terms of absolute annual cash flows, cumulative cash flows for break-even/paybacks and for NPV. Much focus is usually placed on predicting the cash flows of the alternatives, yet in many cases insufficient effort is placed on fully comprehending the Status Quo. One of the biggest pitfalls is to assume that the Status Quo is indeed the Status Quo. Doing nothing, whether it is investing in infrastructure or in R&D, will certainly have negative impacts on the health of a company or of a building. Let’s look at a simple example.
A firm has decided not to invest renewal dollars in its buildings which require maintenance dollars. Avoiding the investment will lead to improved short-term cash flows, but in the longer-term the Status Quo will, really, not be the Status Quo. Continual deterioration will reduce the Class Rating of the buildings which will result in lower net rents. Combining lower net rents with a lower capitalization would be disastrous for valuation. In addition, the firm should determine the financial impact of: lower employee productivity associated with poor working conditions; the effect on absenteeism related to health and safety issues; the negative impact on the firm’s customer perception and it’s impact on prices and margins.
Identifying and quantifying all the issues related to a “do nothing” Status Quo is certainly challenging but the deterioration needs to be recognized and the forecast must nevertheless be done.
Terminal/Residual Values
One of the key drivers of value in a real estate analysis is the terminal value of the property at the end of the study term which is then discounted to the present. Given that the terminal value is an estimate that goes far into the future, its reliability needs to be weighted in the overall decision. Further, the terminal value is based on a particular building’s net cash flows and the capitalization rate at the time. Both of these determinants in turn require underlying assumptions concerning future economic conditions, general inflation rates, energy inflation rates, the future “Class” of the building as it ages, interest rates, etc. Given the risk that these key assumptions can differ materially in the far distant future, the present value of the terminal value needs to be put into perspective relative to the total NPV of the project. If most of the NPV of the project is being derived from the terminal value I would suspect that the financial success of the project will ultimately be at risk.
In conclusion, it’s always best to be conservative. Of course, all analyses are already conservative and every failed project’s analysis was presented as being conservative. Have you ever come across a situation where an analyst has introduced his analysis by saying “Let me start by saying that all our assumptions are not conservative”? Being conservative implies addressing all the factors discussed above, and even then, applying a safety margin or a contingency. Caveat Emptor!
William Jegher is President of Wika Consulting, a consulting company specializing in facilities management and real estate benchmarking, communications and consulting. Contact him at wjegher@wikaconsulting.com
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