Archive for February, 2012

The DCF Method of Analyzing Income Property Needs to Change

Saturday, February 25th, 2012

By Bruce J. Coin
Director, Bruce Coin Consulting, Inc.

While much of the focus during the remainder of this year will be on the national election, it is clear that cautious optimism now abounds about an improving national economy.  Many, but not all, of the carefully monitored economic barometers are confirming a continued but modest growth. At their January meeting the “Fed” left interest rates unchanged and commented that “the expectation is that the fed funds rate will remain exceptionally low until late in 2014”. This bodes well for business and the commercial real estate industry that are substantially dependent on financing.  Consistent with their past promises of more “transparency” the minutes of their February meeting included a tremendous amount of additional information and some insight into board members thinking.

As the economy expands and commercial real estate again receives increased investor and lender attention, a real concern is the way that Discounted Cash Flow (DCF) analyses are being used to analyze income properties and estimate their values and internal rates of return or IRR. 

In the mid1980’s, appraisers, analysts and investors started using a 10 year income and expense analysis to estimate the value of an income property and its potential IRR.  The projection process became known as a Discounted Cash Flow Analysis or DCF for short. The 10 year period became the acceptable “norm” and was identified as the “typical holding period”, i.e., the assumed or estimated time period that an owner would typically retain ownership and operate the property before selling.

The ever increasing availability and use of computers and “canned” software programs such as the early Lotus and more recent Argus facilitated increased use of the analysis and permitted the analysts to perform their projections much more rapidly than by hand using a calculator. The problem is that no one has changed how these projections have been done for years.  I submit that it is now time to recognize that “garbage in” produces “garbage out” i.e. the reliability of a DCF analysis is only as good as the assumptions used to generate the analysis and the skills of its creator to properly direct the software to produce a product that is properly customized to the facts and forecasted information for the property. 

The benefit of performing a DCF, as opposed to using a single stabilized year approach known as “Direct Capitalization (using a “cap rate”) and capitalizing a “stabilized” annual net operating income into value, is that a DCF analysis permits its creator to consider and estimate virtually every income, vacancy, expense and capital item on a year by year basis over the forecasted “holding” period.  Typically a ten year forecast is generated although a DCF can be created and applied to longer and shorter time periods. In uncertain times a five year analysis may be more reliable.

One very significant problem associated with running a canned program to create and perform DCF calculations is often the un-admitted but true lack of more than a surface understanding of how to properly use the program by its author.  As a result, many analysts allow the program to perform any number of tasks without giving the amount of individual and meticulous attention and instructions that the case warrants. This is especially true after they have input the information for only the first year or two. When they do that the preprogrammed formulas take over and produce results that often are not truly reflective of the intent. 

In addition, these preprogrammed formulas and calculations often use built in averages, “blends” or standard formulas that have not been overridden by the analyst who is really the “programmer”. They don’t override them because they either do not know how or they don’t want to invest the additional time to seriously and more carefully think about some things that may occur in the 4th or 5th years or thereafter. 

To dramatize the impact of projecting that rents and expenses will all go up by pre-ordained, but hypothecated  percent per year, I have provided a brief and very simple basic example (due to limited page space) assuming that the annual real estate taxes and operating expenses of an income property are initially 45 percent of a property’s annual gross income. In many cases the taxes and expenses are more or less than 45 percent.

Escallation factor 3 percent per year:

Year  3 5 10
Gross Income:    $1,000,000 $1,030,000 $1,060,900 $1,125,550 $1,304,819
Taxes & Expenses:  $450,000 $463,500 $477,405  $506,479 $587,147
Property’s annual net income:   $550,000  $566,500 $583,495 $619,071 $717,147

Wouldn’t it be nice if all investments performed that way? 

The use of an Excel spread sheet, where line by line and year by year figures must be estimated and individually entered is probably a more reliable way to perform a DCF especially when the property is encumbered by multiple leases.  The process takes much more time that cranking out an Argus run after inputting first year or three year’s numbers and then asking the program to apply factors such as increasing the annual income and expenses by a given percent per year forever over the holding period.  

Going line by line in and year by year in an Excel spreadsheet forces the analyst to actually think more about the future actions of individual tenants, lease expiration dates, the impact and viability of any existing renewal options, tenant reimbursements/contributions, base year expense stops (where applicable) as well as annual real estate taxes, operating expenses and capital expenditures for such items as tenant improvements and leasing commissions to brokers to retain or attract new tenants.

I have recently informally reviewed the DCF analyses in the appraisals of over eighty income properties located in twenty seven states with a concentration in multitenant office buildings.  I have been astounded to see many commercial appraisers continuing to estimate that the rents and expenses of multitenant properties will still escalate year after year on a straight line basis over a 10 year holding period by using annual escallation factors of 2.5 to 5 percent in their DCF analyses.  They are obviously ignoring the lessons of the past 4 years as well as the post WWII history of economic recessions and practical economic theory.

Since WWII, recessions have occurred in this country in a range of every two to ten years with two and ten year hiatus periods being atypical.  Most occur every four to eight years and often close to national elections.  When recessions occur, property vacancy rates increase, rents go flat or actually decline while most operating expenses continue to increase. It doesn’t always take a national recession to have the same impact.  Changes in supply and demand can have the same effect in a community or even a region.  Overbuilding, employer relocations, technological advances, social change and other factors can often flatten rental rates and increase the vacancy of a particular property or group of properties.

For the past few years the way that most have been creating these DCFs appear to be merely based on an almost standardized and rote method of thinking but while many properties exhibit similar characteristics many are individually very different.  Accordingly, I submit that it is now time to recognize that how these forecasts have been performed needs to be changed.

My former company, Pro-gressive Mortgage Corp. was a mortgage loan correspondent and loan servicing agent for insurance companies and other institutional investors for thirty five years. Every year a servicing correspondent is required to inspect the property and review the annual rent rolls and income and expense statements for each and every property secured by the loans they service. A written analysis and report must be provided to the lender-investor. At one time we were servicing a portfolio of approximately $500,000,000.  Accordingly, we saw firsthand that;

  • in some years rents went up more than a property’s operating expenses
  • in some years a property’s expenses went up more that the rent increases
  • in some years a property’s market rents actually went down from what they had previously been able to obtain
  • many times the actual vacancy rates of a property changed significantly from year to year
  • no multitenant property’s annual income, annual expenses or net income all increased steadily from year to year

When a DCF is being created, prudence suggests (and I say demands) that it incorporate forecasts that do not simply project everything increasing at a rate of some hypothecated   percentage rate over the next 10 years but should reflect more sophistication that includes consideration of future economic downturns and recessions. Opponents to this intelligent and necessary change cite that when they make such up, up and away forecasts they are only mirroring what investors do and are replicating the actions of the market.  Personally, I don’t believe that excuse as I do not know any investors that would make such an unrealistic assumption over such a long period of time. Maybe that is because it really is their money they are thinking about and how future conditions and projections will impact their own money because they are not just providing an opinion to someone else.

Think about the foregoing and I believe you will agree that the likelihood of rents increasing steadily every year over a 10 year time period is literally ludicrous thinking.  If it were a valid assumption one would think that stock brokers would be telling customers to buy stocks because their dividends would increase every year by a pre-ordained percentage.  We all know how that message would be accepted so why has this past method of doing a DCF simply been accepted?

If you really want to test a DCF that was prepared for a multitenant office, retail or flex-industrial building, just incorporate a reasonable amount of mortgage debt service because they are all typically created without incorporating the annual debt service of a reasonable mortgage. They all assume an all cash (unleveraged) purchase and that all of the imminent and future costs of tenant finish and leasing commissions are paid out of annual cash flows. Depending upon the particular case, in some years they actually show a negative cash flow as the tenant improvement and leasing commissions exceed the annual cash flow. No explanation is given as to where the money to cover those costs comes from. In addition such a loss is not carried forward into the next year to be (potentially) absorbed by the next year’s cash flow. In years where that does not occur, the after improvements cash flow is often low enough that there is not enough to pay the annual debt service or if there is it doesn’t “margin” the loan sufficiently to meet the lender’s debt service coverage requirement.

What is necessary to really do one properly and on a more meaningful basis than the current practice is to incorporate a combination of up-front cash (reserve) to cover the imminent tenant finish and leasing commission costs as well as an annual on-going reserve to reasonably cover those future costs but they just don’t do it.

I guess the comedian W. C. Fields was right when he said that  “ there is a sucker born every minute”.  I have seen many less than truly sophisticated investors accept such DCFs and invest in a property only to lose their money because the property never could have performed to the level estimated by the DCF that was initially used to seduce their investment.

When I see such a forecast it makes me very suspicious and impacts the credibility of the projection and forecaster. Now, when you look at one, you can make your own decision, are you a sucker or not?

It really is time for them to change. If you are preparing one, make sure you change the way you do yours.