MARKET VALUATION BASED ON DISCOUNTED CASH FLOW ANALYSIS - CONSISTENCY IN ASSUMPTIONS Stellan Lundström Royal Institute of Technology Christina Gustafsson IPD Norden

Background 1997 Establishment of the Swedish Property Index in co-operation with IPD A quality control process for index valuations An ambition that assumptions should be consistent

Data source 1997 – 2008: Valuations – 83 % with DCF technique –All DCF assumptions and results are in a database

Main initial observation Valuation accuracy tested to be on a good level. Feed back on DCF parameters raises question about the relevance in assumptions about discount rates, exit yields, rents, vacancies, operations and maintenance

Research questions Main question ”How are DCF assumptions related to each other Specific question ”What is the meaning of DCF yields and discount rates when DCF is used for market valuations”

The Swedish Leases – short and gross Operation & maintenance cost as % of gross rent Source: IPD Multi National Index Spreadsheet 2008

Office rents in Stockholm CBD Source: IPD

Initial and long term vacancy rate in valuations Office Stockholm CBD, 1st January = Assumptions in valuations long term = Actual outcome = initial vacancy rate Source: IPD

Assumed operations and maintenace costs in relation (%) to actual outcome Sector / Year Retail Office Industrial Residential All Properties Source: IPD

Sector Actual/Valuations NOI Retail 80 Office 91 Industrial 82 Residential 87 All Properties 88 NOI year 2007 Source: IPD

Valuation yield (exit yield) % Discount rate, % Valuation of Office properties in Stockholm CBD Discount rates and exit yields Source: IPD

Year Nominal Discount rate Nominal rental growth Implicit Exit Yield Explicit Exit Yield in valuations rg r-g ABA-B Average Implicit vs explicit yields Source: IPD

Average values for input variables in the valuations n NOI 0time 8.7 – 3.3 = 5.3 < 6.9

Conclusions ”All assumptions are biased – the result is OK!” The same discussion as 30 – 40 years ago Swedish valuers has developed; –An industry standard for valuation –A market monitoring system

Implications Valuers - legitimacy Investors – Interpretation of and need for decision support Auditors– new role due to IFRS –Opinion about Market value (fair value) Assumptions behind market value To value ”green buildings” there is a need for more explicit assumptions about NOI