Discounted cash flow analysis in property investment valuations

Abstract

Employs discounted cash flow analysis as a valid method for valuing future cash flows from property investments. The method has regard to the market participants’ investment behaviour and thus is able to encapsulate the economics of the investment decisions made; particularly by institutional investors. Observes, however, that there has always been serious concern about discounting property investment returns using discount rates that predicate long‐term bond yields. Reports on a comparative study between Australian ten‐year bond and the prime Sydney and Melbourne office yields which has been carried out to find out if there is a correlation. The relationship between the two yields for period March 1980‐March 1995 shows an inverse relationship, i.e. a negative correlation between the two yields. The result is consistent for both studies. The actual f‐value of 89 for Sydney office yields versus bond yields and 110 for Melbourne office yields versus bond yields, respectively, when compared with the table f‐value of 7.08 for the data set, indicate that the negative relationship is significant. Argues, in addition, that the achieved R2 of 60 and 65, respectively, indicates that the explanatory power of the model is acceptable. So a discount rate based on bond yields, in the rising bond market, will indicate a higher future return from the property investment. Concludes that the result is totally flawed, given the inverse relationship between bond and property yields, because the actual future return will be lower; and that, as a result, in the rising bond market the prospective property investors who ought to achieve higher future return will actually end up achieving a lower return. A converse flawed result will be achieved in the falling bond market. In this market the vendors using this method to calculate the exit value of their investments are actually accepting an incorrect lower price.