Direct capitalisation assumes a perpetuity of stable income. A discounted cash flow does not, which is why it is the right tool whenever the near-term income is going to change: a lease rolling, a floor being re-let, a renovation finishing.
How do you build a property DCF?
The build has five parts and one trap.
- Project net operating income for a holding period, usually five or ten years, from the rent roll rather than from a growth rate where you can.
- Choose a terminal cap rate for the exit. Convention adds 25 to 75 basis points to the going-in cap rate, because the building is older at exit and because assuming otherwise embeds a bet on cap-rate compression.
- Compute the reversion: the year after the holding period's net operating income, divided by the terminal cap rate, less selling costs.
- Discount everything at the property discount rate, which is the unlevered required return on the asset rather than the cap rate.
- Reconcile against direct capitalisation and explain the gap, rather than reporting whichever answer you prefer.
The trap is the reversion's weight. In Worked Example 2 the reversion is 69.30% of the total value, so the exit assumption dominates a build that spent most of its effort on the first five years. Move the terminal cap rate from 7.00% to 9.00% and the value falls from $44.17 million to $37.09 million, a swing of 17.60% of the base valuation, while moving net operating income growth across the whole plausible range from 2.0% to 4.0% moves it by 7.86%. A property discounted cash flow is mostly a statement about the exit.
Say the exit cap rate out loud before you say the value.
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How do you reconcile a DCF with direct capitalisation?
Reconciliation is where the two methods teach each other. Direct capitalisation at a 7.1162% cap rate implies perpetual growth of 8.75% - 7.1162% = 1.634%. The discounted cash flow's 8.00% exit cap implies 8.75% - 8.00% = 0.750%. The 0.884-point difference in implied perpetual growth is the whole explanation for a 4.12% valuation gap, and you can prove it by solving for the terminal cap rate that reconciles the two: 7.5324%, which is 46.76 basis points below the assumed exit cap and 41.62 basis points above the going-in cap. Stating that sentence is what separates a valuation from two numbers on a page.