As experienced developers and financiers of development projects well know, the valuation conclusion can be very sensitive to the variables of a development feasibility.
And the discount rate applied to the discounted cash flow (DCF) analysis for a development valuation is no exception.
The Royal Institution of Chartered Surveyors (RICS) valuation standards Red Book, including the new 2017 International Valuations Standards (IVS) makes for interesting reading for valuation professionals and users of their services, due to some new refreshing flexible thoughts and directions on valuation issues.
A particular point of constraint and inflexibility in the valuation industry has traditionally been the selection of an appropriate discount rate in a DCF analysis and valuers have been restricting themselves to the generally accepted methods such as:
- Rate selection by abstraction. Finding enough pertinent information about relatively similar property transactions to establish their Internal Rate of Return. Very hard to get honest and reliable data.
- Rate selection by market This is a market but not property specific rate.
- A synthesised rate consisting of a base rate such as the risk-free rate percentage and then add any reasonable percentage for property and property market perceived risk factors.
- Capital Asset Pricing Method. Good luck in finding a Beta, a measure of volatility compared to the overall market.
- Weighted Average Cost of Capital. Again, good luck in finding the Beta for the equity component.
However, the latest Red Book (IVS) states “To arrive at the discount rate a valuer may use any reasonable method for developing a discount rate”.
The effective word is “reasonable” and this factor is now underpinning the discount rate selection criteria instead of a selection by an inflexible prescriptive system, which can only improve the efficacy of the valuation.
Whilst great care and skill is required to accurately assess the appropriate discount rate for any valuation involving DCF, this flexibility better allows for well-reasoned judgements on an appropriate rate which becomes most critical on marginal developments.
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