Discounted cash flow
Discounted cash flow is a valuation method where expected net rental income and an estimated sale value (exit) over an analysis period (typically 5 to 10 years) are converted into a present value using a discount rate. The method is used to complement or replace a direct capitalisation rate when the cash flow is not stable, typically when a building has a short remaining lease term, large upcoming tenant improvements, or a transformation phase ahead of it.
The core of the model is a periodic cash flow: contract rent in each year adjusted for CPI indexation, market rent roll-over when contracts expire, and deductions for vacancy, operations, owner costs and capital reinvestment. In the final year, a terminal item is added to represent the sale value (exit value), calculated by applying a reversionary yield (also called exit yield) to that year's stabilised net rent. The sum of the present value of all annual cash flows plus the present value of the exit value is the building's value in the model.
The discount rate is the most important assumption in the method and normally consists of a risk-free rate (10-year government bond or swap rate) plus a risk premium for the property market, the segment, the location and the building's specific risk. Many analysts distinguish between the discount rate on rental income (around 6-8% before gearing for Norwegian commercial property) and a lower rate for the contracted parts of the cash flow. The sensitivity is high: a change in the discount rate of 50 basis points can change the value by 5-10%, depending on the duration of the cash flow.
The model is superior to direct capitalisation when the contract rent differs from the market rent (see reversionary yield), when there are known one-off costs (refurbishment, tenant improvements at contract renewal), or when the building is in the middle of a development phase. It takes more work: every assumption (market rent growth, CPI, operations, vacancy, exit yield) has to be justified. Norwegian brokerages and valuers often provide both a direct value and a cash flow value in the same report, where the difference between them shows how sensitive the model is.
In practice, discounted cash flow is the dominant method for commercial property with a short remaining lease term or development potential, while direct capitalisation is used for stabilised buildings with long contracts. The internal rate of return of the cash flow is the parallel measure of the investment's return and is often reported alongside the present value.
In Placepoint you can compare contract rent, tenants, remaining lease term and building standard from the property panel as you fill in the assumptions in a discounted cash flow model.
How this looks in Placepoint
In Placepoint you find this in Property panel - Units and Tenants:
From Placepoint's glossary: Discounted cash flow
More information: Eiendom Norge: Market reports, Akershus Eiendom: Market Report, Store norske leksikon: kontantstrøm
English: Discounted cash flow (DCF).
Frequently asked questions
When should I use discounted cash flow instead of direct capitalisation?
When the cash flow is not stable. That is: the building has a short remaining lease term, the contract rent differs from the market rent (reversionary yield differs from net initial yield), there are known one-off costs ahead (refurbishment, tenant improvements), or the building is in a transformation phase.
How do I set the discount rate?
Risk-free rate (10-year Norwegian government bond) plus a risk premium for the property market, the segment, the location and the building. For Norwegian commercial property, levels are typically 6-8% before gearing. The premium is justified against observed yield levels for comparable buildings and against the buyer's required rate of return.
Which analysis period should I use?
5 to 10 years is common for stabilised buildings, 10 to 15 years for development or transformation. Longer periods make the model more sensitive to the exit yield assumption, shorter periods make it more sensitive to the discount rate.
How is the exit value calculated?
Stabilised net operating income in the final year divided by an exit yield, which is today's reversionary yield plus an age premium of 25 to 50 basis points. The exit value is discounted back to today and added to the sum of the present value of the periodic cash flows.