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PRACTICE PAPER

The Australian Institute ofValuers and Land Economistsdiscounted cash flow practice

standardSpike Boydell

University of Queensland, Gatton College, Queensland, Australia, and

Stuart GronowCentre for Research in the Built Environment,

University of Glamorgan, UK

IntroductionThe Australian Institute of Valuers and Land Economists Incorporated(AIVLE) Practice Standard No. 2, Practice Standard Discounted Cash Flow(1996), issued by the Australian Valuation Standards Board was formallylaunched in Brisbane on 30 August 1996 by the Hon. John Moore MP, Ministerfor Industry, Science and Education.

In introducing the standard, Bob Connolly, Chair of the National ValuationBoard of the AIVLE, offered a background to the establishment of themandatory standard. Through the late 1980s, as the property market inAustralia went into recession, criticism was laid on valuers by certain investorsfor not adopting a discounted cash flow (DCF) approach. While the principle ofnet present value (NPV) was mentioned in theAustralian Journal of Valuationback in the 1930s and 1940s, the concept of discounted cash flows have had avery rough ride in Australia until recently. It could be argued that this maylargely have been the fault of the AIVLE or even its National (federal) President.When Alan Hyam (the 1993 National President) attended a conference at theUniversity of Queensland he stated that the DCF was an unacceptable method,

untested by the courts. He reinforced this view in a letter in theBuilding Ownersand Managers Journal(Hyam, 1993, p. 6):

it [the DCF] is in the main used as a check or alternate method of valuation because of thenumber of forecasts and estimates which must be made

and

Journal of Property Valuation &Investment, Vol. 15 No. 1, 1997,pp. 58-69. MCB University Press,0960-2712

The authors wish to acknowledge the help of Brian Waghorn for his valuable comments andadvice during the preparation of this paper.

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Unless properly applied and qualified the DCF method could leave the valuer open to actionsfor professional negligence should his forecasts prove inaccurate and are subsequentlyadjudged to be arrived at without the exercise of reasonable skill and care. Thestandardisation of the method may accentuate this risk.

However, less than three years on, the method has now been standardized.Fortunately his successor, Gary Rothwell, was a property director of a merchantbank, where DCF appraisal was the norm. Around this period JLW Researchlaunched a supportive Property Research Paper Capitalisation and DiscountedCash Flow: Br idging the Gap(JLW Research, 1992). This was followed by Bill

Toxwards useful AIV LE Research NotesAn explanation of discounted cashflows, their use in the valuation and investment process and selected case

studies (Toxward, 1993/1994). The National Valuation Board of the AIVLE raninitial seminars for investment valuers in Sydney, Melbourne, Perth, Adelaideand Brisbane during mid-1995 to canvass practitioner views, and thereafterrefined by a committee of ten in Sydney. This committee attempted to codify thegeneral views on how property should be valued.

The standard was developed by the AIVLE to provide guidance in theapplication and construction of DCF valuation and investment analysistechniques and became effective as from 1 September 1996.

General concepts of DCF analysis, applications of DCF analysis and thelayout of such models are covered by the standard which is mandatory for allmembers of the AIVLE, although departures are permitted provided thatdisclosures to that effect are made.

The standard relates to DCF valuation and investment analysis techniquesonlyfor which valuation is defined as the process of determining the marketvalue of real property and investment analysis as the process of assessingthe worth or performance of an investment to either a particular person or body,or the broader market and typically includes but is not limited to: feasibilitystudies; reviews of investment performance; the assessment of capital worth ona basis other than market value; and the analysis of transactions.

The three general principles on which the standard has been based are:

(1) cash flows derived from real property should be treated in a consistentmanner for valuation and investment analysis purposes;

(2) where practical, conventions used by other investment markets shouldbe used in the construction of cash flow models; and

(3) relevant standards and other guidelines should also conform with therequirements of International Valuation Standards, the CorporationsLaw, Australian Accounting Standards, Statements of AccountingConcepts and circulars from the Insurance and SuperannuationCommission where applicable and any other relevant legal and industryrequirements.

The standard was adopted after consultation with leading practitioners inAustralia but this does not at first sight appear to be comprehensive andcertainly the views of the academic community have not been sought. The

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result is that the standard does not represent contemporary thinking in theevolution of the valuation/appraisal process, tending towards the current (oreven historic) approach to DCF modelling rather than being forward-looking.

Thus, for example, the need for more explicit consideration of the three keyvariables of growth, risk and depreciation are not addressed. There is also aneed for clearer definitions of yields which are commonly misunderstoodwithin the comparison of evidence.

ApplicationThe standard applies to DCF valuations or investment analyses for thevaluation and analysis of a property or portfolio of properties and it is

considered appropriate to use DCF modelling as a method of valuation, intypical circumstances, for:

income producing property, including commercial, industrial, retail andtourism property;

development projects; and

land subdivisions.

The standard states that it is up to the valuer or land economist to assesswhether the use of DCF is appropriate in a given situation and outlines thefactors likely to affect a courts assessment of the appropriateness and use ofDCF analysis. This latter includes:

market adoption of DCF analysis; comparative use of different valuation methodologies including DCF

analysis as a primary or secondary valuation method;

availability of reliable information about comparable transactions;

criteria affecting selection and application of appropriate discount rates;

other contextual factors.

ConceptsIncluded in the standard are basic definitions of DCF, net present value (NPV)and internal rate of return (IRR).

The discount rate to be adopted or found from analysis is defined both in the

standard itself and additionally in the accompanying guidance notes in thefollowing terms:

The discount rate which is to be used to calculate an NPV is typically abefore tax, nominal, ungeared rate.

In relation to property valuation the discount rate should be the returnrequired by a hypothetical purchaser for that particular property overthe term of the cash flow. The return required by a particular investorwill be that required taking into account the propertys class (retail,commercial, industrial, etc.), physical attributes, location, development

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potential, level of risk and the amount of money invested. For balancesheet valuations, on the basis of the assumption of a going concern, adiscount rate which reflects the companys required rate of return (bothdebt and equity) may be more appropriate.

The discount rate should not take into account the following: rentalgrowth including reversions; vacancies during the term of the cash flow;the potential to increase occupancy levels; and the level of outgoings andrepairs and maintenance.

By implication the discount rate reflects the level of risk of achieving theprojected cash flow.

In relation to investment analysis the discount rate should be theinvestors required rate of return or weighted average cost of capital(WACC). When providing specific financial advice to a particular client,the client should be consulted as to relevant discount rates and therequired rate of return.

There appears to be some confusion in the terminology between nominal andeffective rates of interest. It is also worth noting that the pretax, nominal,ungeared rate is not the same as the weighted average cost of capital so thatdiscount rates will be calculated on differing bases if both are used. Again, itwould be hoped that the discount rate would reflect the inflation risk free yieldplus a property specific risk premium.

WACC is primarily an accounting rather than a valuation/appraisal term.Indeed, this is symptomatic of some of the difficulties in terminology within theAustralian property market, which commonly lends its origins to a hybrid ofUS and UK texts and practices. Wurtzenbach and Miles (1995, pp. 357-8) onlymake reference to WACC in valuing a firm. No mention is made of WACC byWhipple (1995) in his new, and definitive, Australian text Property Valuationand A nalysis. The other two useful recent Australian valuation texts byRowland (1993) and Robinson (1989) only make limited reference to it. Rowlandacknowledges the use of WACC as a screening device for investmentcomparison between say trusts and managed funds, but clearly separates itfrom the discount rate.

Industry standards for discounted cash flowsSpecific mention is made as to what should be incorporated in any cash flowand those factors which must be included. These are represented graphically inFigure 1, with anomalies and some revision suggestions highlighted in Figure2. Specific issues are considered under the following headings.

Purchase and sale costsA cash flow report must state explicitly whether or not purchase and sale costsare included or excluded. For valuations it is mandatory that both must beincluded in the cash flow model and for investment analysis in most

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Figure 1.AIVLE discounted cashflow practice standard

Figure 2.AIVLE discounted cashflow practice standard(anomalies andsuggested revisions)

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circumstances they should be included. Where a development includes the saleor purchase of property as part of that development it is mandatory to includepurchase and sale costs.There is therefore some inconsistency in dealing withthese costs which should be approached on the basis of as you analyse so youvalue and on the same basis as competing forms of investment (bonds andequities) so that a realistic comparison of IRRs can be made for investmentanalysis.

Rest periodsThis refers to the frequency of cash flows (that is annual, quarterly, monthly,etc. the length of one discounting period used in the cash flow). The cash flow

must state explicitly what rest period has been used and the time within thatperiod at which the cash flows are assumed to occur (i.e. in advance or inarrears). For presentation purposes a different period may be used. Thus, rentfrom commercial property may be received monthly in advance and outgoingspaid monthly in arrears. Whereas the actual IRR and NPV calculations shouldbe performed on the actual rest periods, for presentation purposes the summaryyearly totals can be supplied. Where rest periods other than annual periods areused the results from the cash flows must be converted to annual effective rateswhere applicable.

Term of the cash f lowThe term of the cash flow is the length of period of projection of a cash flow the term of the cash flow can vary from case to case. For development appraisal

this will normally be from inception to disposal of a completed scheme. Forinvestment appraisal, however, it would have been beneficial to adopt astandard of say ten years so that both valuation and analysis would beconsistent and IRRs could be compared with purpose and accuracy.

Terminal valueIn discounted cash flow valuations a terminal value must be included whichreflects the propertys value at the end of the term. When using the conventionalcapitalization of income approach for determining the terminal value, thepassing annual net income as at the commencement of the year immediatelyfollowing the last cash flow of the term must be capitalized allowing for anymarket reversions. Where the terminal value is calculated on any other basis,

this must be disclosed and described in a cash flow report.In determining the terminal value, no mention is made of explicitly takingaccount of the age and depreciation of the property as at the date of the disposalin regard to the fact that the property has in fact aged during the time of theholding period itself and this should be reflected in the yield to be used.

Analysing sales evidence to support a discounted cash f lowAny analysis of sales evidence must be carried out on a similar basis to thatused in the valuation or investment analysis of the subject property. Thestandard states that it would be preferable, provided that sufficient information

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is available, to derive the underlying IRR as an indicator as to appropriate ratesof return for subject properties.

Cash f low resultsCash flow results must be presented on a nominal, before interest and before taxbasis. Where investment and finance details are to be included these are to beshown separately. For calculating NPVs a single discount rate applicable to theterm of projection should be used (mean NPV).

Sensitivity analysis for assessing the volatility of the cash flow is said to beencouraged for both valuation and investment analysis and for this the keyvariables include (but are not limited to): the discount rate; escalation rates; the

terminal capitalization rate; and capital expenditure during the term of the cashflow. These key variables can be summarized more usefully as:

risk related to the discount rate and the terminal capitalization rate;

growth the word escalation rate has been used which is less clear;

depreciation this should be incorporated both within the term periodand in the terminal capitalization rate.

There is no guidance, however, as to how these should be considered andaccounted for explicitly.

Layout of discounted cash flowsThis is covered under the following headings.

Commencement dateThe commencement date must be disclosed at the start of the cash flow and inany accompanying report. In numbering periods, the first period must bereferred to as period 1.

Part per iodsWhere a cash flow does not run for an integral or whole number of periods, thepart period must be treated as the last period and cash flows and the cash flowmodel itself must be adjusted appropriately.

InflowsInflows may be grouped and categorized for presentation but separate

headings must be provided for inherently different sources of cash flows andthese must have separate but not necessarily different escalation rates. Fordevelopment projects involving subdivisions, selling costs must be shownseparately and deducted to arrive at a net realization. Any vacancy allowancesshould be based on the tenancy profile taking into account the loss of inflowsand recoverable outgoings.

OutflowsSimilar provisions apply for grouping of outflows, etc. as for inflows above.Cash outflows for valuation purposes must include a provision for future

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capital expenditure which can be by way of a lump sum in a particular periodor over a term of periods or as a periodic contingency allowance or as acombination of both.

Net cash flowsNet cash flows, being the sum of inflows less the sum of outflows, must beshown separately for each period.

Investment and f inance detailsA cash flow which details taxation, equity and finance issues must group suchissues and total them separately and distinctly from the inflows, outflows and

net flows. DCF valuations must be prepared on a before tax and before financebasis, including valuations for hypothetical development purposes and landsubdivisions. For investment analysis purposes, if the effect of taxation benefitsor costs is incorporated their timing must be taken into account and, unlessthere is some reason for not doing so, the prevailing company tax rate should beused.

Net present valuesCash flows should provide either the present value of the net cash flow for eachperiod (both before and after tax and interest where applicable) or the presentvalue of all individual cash in and outflows (including taxation and financedetails where applicable) from which the NPV can be reconciled.

T iming of f inanceWhere a gearing ratio or level of equity is to be incorporated the cash flow mustreflect the periods in which such capital is injected.

Funding shortfallWhere the sum of equity and finance is insufficient to fund all the capitalrequirements, the cash flow report must state explicitly the shortfall amount, itstiming and a discussion of possible implications. The shortfall amount will bedeemed to be met by finance and cash flows adjusted accordingly.

InterestWhere interest payments are included in a cash flow the amount of interest

charged per period must be shown. Interest should be calculated periodicallyand not included as a lump sum unless there is specific reason to do so if it isincluded as a lump sum, this must be stated explicitly and any implicationslikewise. The rate at which periodic interest is calculated must be shown clearlyand expressed as an annual effective rate. If the interest rate varies from periodto period, the annual effective equivalent interest rate must be shown for eachperiod. This applies also for rest periods. Usually, market rates should be usedfor the calculation of interest but, if this is not the case, the cash flow reportmust state explicitly the annual effective rate used, that it is not a market rate,the reasons for its use and any possible implications. If actual interest payments

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are known they should be used and the report should state this explicitly. DCFsthat include interest calculations should be structured so as to take into accountany expected increase or decrease in interest rates for the term of the cash flowbased on evidence available at the date of the analysis. Where interest receivableon credit balances is to be calculated and shown in the cash flow, the amount ofinterest received per period must be shown separately. If actual interest receiptsare known, these should be used and the report should state them accordingly.Where actual interest payments and/or receipts are not known, then interestmust be calculated on the appropriate capital figure as at the end of the previousperiod and, applying the period interest rate to that amount, the interestpayment due or receivable must be calculated.

Reflecting cash f lows over timeThe standard acknowledges that any projections, escalations and estimates offuture growth or decline can only be based on information as available at thedate of valuation or investment analysis and states that all cash flows in thefirst period must be sourced from direct evidence if available, for example fromtenancy schedules and budgets of outgoings. If market rentals are to be used,due regard to market practice must be taken in relation to lease incentives, leaseterms, the nature of rent reviews, the responsibility for the payment ofoutgoings and other relevant factors and also to any possible changes invariable outgoings resulting from an increase in occupancy. Provision for leaseincentives, if applicable, should reflect prevailing market practice which, as

with the other matters mentioned previously, are not defined in the standard. Itis mandatory that cash flows reflect anticipated changes over the term of theprojection including the impact of growth or decline in values, rents, costs andany other item. In cases where an option exists to renew an existing leaseduring the period of the cash flow, the valuer/land economist must decidewhether the option is likely to be exercised and adjust the cash flow accordingly if the decision is that the option will not be exercised, market lease conditionsmust be assumed at the date for exercising the option. Where clientsinstructions are to the contrary this must be specifically noted and acommentary provided as to possible implications. A separate table ofassumptions must accompany a DCF model specifying clearly all escalationsand growth rates in annual (inclusive of inflation) terms.

Reporting requirementsA report must accompany all discounted cash flows and detail the following:

the purpose of the report, whether it is for valuation or investmentanalysis;

where a NPV has been calculated, a discussion of the adopted discountrate;

whether or not purchase and sale costs were included or excluded in thecash flow;

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what rest period was used;

where the terminal value was calculated on some basis other than theconventional capitalization of income approach, a disclosure anddescription of the approach used;

a disclosure if there is a funding shortfall and, if so, a discussion ofpossible implications;

where interest payments have been included in a cash flow as a singlecapital sum (capitalized interest), a statement to that effect alsoindicating in which period it is included and a discussion of any possibleimplications from using such an approach;

if a provision for lease incentives has been included by a means otherthan using effective rentals and rent free periods, a discussion of anypossible implications from using such an approach;

identification of the author or developer of the cash flow model or, in thecase of a software package, identification of the product name andversion;

identification of the user of the cash flow model;

identification of the date on which the cash flow was produced.

Appropriate limitations, qualifications and disclaimers must be included,having regard to the nature of the instructions and the extent of the informationprovided by the instructing party and its representatives and, when required,

any report accompanying a cash flow must make clear and unequivocaldisclosures.

Any departures from the standard, absence of full documentation or thepresence of specific assumptions resulting from special circumstances must benotified in a Statement of exceptions to the AIVLE cash flow standard, whichmust be attached to both the cash flow and the cash flow report if both are notincluded in the same document.

Where the cash flow is compiled for valuation purposes, the valuer shallrequire as a condition of engagement that any special limitation, assumption ordeparture be disclosed in any document in which reference is made in relationto the cash flow.

The guidance notes also strongly recommend that regular valuations

(analysis) be prepared and the results of cash flows be based on informationavailable as at the date of valuation (analysis). Also that reliance on informationafter an extended period from the date of valuation (analysis) should only bemade after written confirmation that it is appropriate to do so by thevaluer/land economist. If information is supplied by others on which some or allof a report is based then a statement should be incorporated to the effect thatsuch information is believed to be correct but that it has not been verified in allcases and that no warranty is given for its accuracy. Likewise a statementshould be incorporated to the effect that the valuation is for the use of the partyto whom it is addressed and is for specific (listed) purpose(s) only no

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responsibility will be accepted for any third party who may use or rely on thereport or any part of it. If a third party wishes to use the report he/she shouldobtain written approval from the valuer/land economist.

ResponsibilitiesThe construction of DCF models must be supervised by an associate, fellow orlife member of the AIVLE who must have appropriate market knowledge andexperience to construct the cash flows and has the responsibility for theintegrity of the model, both in terms of the magnitude of the cash flows and thetheoretical and mathematical correctness. This may well cause some initialproblems for certain practitioners.

International perspectiveTo put the standard into context, it is important to consider the role of avaluer/appraiser within Australia. The valuer/appraiser has to operate within aclear set of practitioner guidelines determined by their overseeing professionalbody in the country of practice. Within Australia it is the Australian Institute ofValuers and Land Economists (AIVLE) whose members carry the designationAIVLE (Val.) determining them as valuers as opposed to economists AIVLE(Econ.); in the USA, the Appraisal Institute members carry the designation MAI(Member of the Appraisal Institute); in the UK, the major overseeingprofessional body is the Royal Institution of Chartered Surveyors (RICS) whosemembers would carry the designation FRICS for fellow or ARICS for associatemembership. Within the UK there is also the recognized Incorporated Society of

Valuers and Auctioneers (ISVA) whose members carry the designation FSVA orASVA for fellow or associate respectively. The situation is further complicatedin the UK because the chartered surveyor undertaking valuations/appraisals inthe context of this standard would be a member of the general practice (GP)division, and a GP chartered surveyor has, hitherto, a far wider advisory rolethan his/her US or Australian counterparts.

It is contended that the Australian valuer and the US appraiser are forced bytheir constitutions to take somewhat of an historical approach to valuation, togeneralize, basing their advice on past transactions or historical comparabledata. This is further compounded by the descriptive and/or demonstrativeapproach to real estate/property education imposed on the university system bythe Appraisal Institute, AIVLE and RICS in their respective countries (Jaffe,

1993). It is left to their investment/analyst colleagues to undertake the futuresapproach based on forecasting and econometric/statistical demographic dataand the position of the investment within the portfolio. Their UK counterparts,while having greater flexibility as to the nature of their professional advice,tend also to fall very much into two camps, dependent on their role (albeitwithin the same company) as valuer or investment property portfolio adviser. Itcan be argued that this separation should not exist, for the term appraisalserves to incorporate both valuation and analysis. Vernor and Rabianski (1993)define real estate appraisal as applied urban land economics which serves toreinforce this view. As the assets in question are often worth several hundred

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million dollars, a historical perspective cannot be taken in isolation. There is aneed to combine the practice/historical approach of the valuer and link it to thefutures role of the analyst within a framework of a real value rational approachas purported by Baum and Crosby (1995).

It is also worth noting, in comparing the Australian situation with overseascounterparts, that the lease structure is very different with leases ranging fromtwo years upwards, annually indexed to the consumer price index (CPI) withreviews to market ranging from two to five yearly intervals. This leasestructure ensures the need for annual growth and/or indexation to beincorporated in the DCF.

ReviewThe practice standard will be reviewed 12 months after its issue date. Inintroducing the standard, Bob Connolly acknowledged that some of the termscontained within the standard lacked common ground and there would clearlybe scope for refinement. However, it was deemed beneficial to launch thestandard in order that it may be fully tested by practitioners, thus elicitinggreater constructive feedback. Comments are welcomed by the AIVLE andshould be forwarded to the National Secretariat, AIVLE, 6 Campion Street,Deakin, ACT, 2600, Australia.

References

Australian Institute of Valuers and Land Economists Incorporated (1996), Practi ce StandardNo. 2 Discounted Cash Flow, AIVLE, Deakin.

Baum, A. and Crosby, N. (1995),Proper ty Investment Appraisal, 2nd ed., Routledge, London.Hyam, A. (1993), Letter,Building Owners and Managers Journal, October, p. 6.

Jaffe, A.J. (1993), Is there a body of knowledge in real estate? Some mutterings about mattering,in DeLisle, J.R. and Sa-Aadu, J. (Eds),Appraisal, Market Analysis, and Public Policy in RealEstat e Essays in Honor of James A. Graaskamp, Volume 1, American Real Estate Society(ARES) Real Estate Research Issues, Kluwer Academic Publishers, Boston, MA.

JLW Research (1992),Capital isation and Di scounted Cash Flow Valuati on: Br idging the Gap,Property Research Paper: December, Finance and Investment Series, JLW Research andConsultancy Pty Ltd, Sydney.

Robinson, J. (1989),Property Valuation and Investment Analysis A Cash Flow Approach, LawBook Company, North Ryde.

Rowland, P.J. (1993),Proper ty Investments and their Financing, Law Book Company, North Ryde.

Toxward, W.F. (1993/1994), An explanation of discounted cash flows, their use in the valuationand investment process and selected case studies,AIVLE Research Notes, Issue 9 (November

1993) and Issue 10 (February 1994), AIVLE, Canberra.Vernor, J.D. and Rabianski, J. (1993),Shopping Center A ppraisal and Analysis, Appraisal Institute,

Chicago, IL.

Whipple, R.T.M. (1995),Proper ty Valuation and Analysis, Law Book Company, North Ryde.

Wurtzenbach, C.H. and Miles, M.E. (1995),Modern Real Estate, 5th ed., John Wiley & Sons, NewYork, NY.

(Spike Boydell is a Lecturer in Property Investment in the Department of Business Studies,Gatton College, University of Queensland, Australia. Stuart Gronow is Professor of Real EstateAppraisal at the Centre for Research in the Built Environment, University of Glamorgan, UK.)

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