The Most Common Fatal Flaw in Discounted Cash Flow Analysis

 

I entered the appraisal profession at an opportune time – in the mid-1980s, when discounted cash flow (DCF) analysis had come into vogue in the real estate industry.  The crowning moment for DCF’s new place in real estate investment analysis became apparent in the purchase of the Pan Am building (now the Met Life building) in New York in early 1981.  The price paid shocked many, as it reflected a “going-in” capitalization rate of just 4% for an 18-year-old building in a time of very high consumer price inflation and very high interest rates.

Manhattan was just awakening, though, from a 1970s stagflation-induced real estate coma of no new construction, and the rapid expansion of the financial industry brought the Manhattan office market to full occupancy, with office rents increasing 50% from early 1979 to the end of 1980.  The buyers of the Pan Am Building relied on a DCF model based on cash flow projections for years into the future, anticipating the ability to re-lease space at much higher rental rates.  In this context, the purchase price was justified.

I was recruited out of graduate school by Jones Lang Wootton, where I was promptly put to work creating DCF models for regional malls and high-rise office buildings owned by their institutional clients.  Because JLW was a full service real estate firm which managed many institutional properties, I had access to many property operating histories. Seeing these operating histories and also consulting publications from IREM (Institute of Real Estate Management) and BOMA (Building Owners and Managers Association), it became obvious that over the life of a commercial building, expenses increase faster than rents.

This can be graphically demonstrated by a typical subset of BOMA data in Figure 1, and is equally supported by IREM data for other property types as retail centers and apartment buildings.  Notice how the line representing the operating expense ratio for each age subcategory increases in slope relative to gross income.  The numerator, Expenses, is increasing faster than the denominator, Gross Income.  This is a graphical proof of expenses increasing faster than income for income properties. Why does this almost always happen?  Because buildings are deteriorating assets.

                              

                                                           FIGURE 1

Data from BOMA (Building Owners and Managers Association)

There is a logical reason for this. As a building ages, it becomes less competitive in its marketplace and the rate of rental increase slows, while the aging of the property requires increasing maintenance and capital improvements expenditures. This is the reality of physical and functional obsolescence.

The natural end of the economic life of a building is when expenses finally exceed collectible income. If expenses typically grew no faster than income, on the other hand, no building would become obsolete. That would be nice for building owners, but the real world does not operate in this manner.

DCF models which forecast expense growth to be the same rate as consumer price inflation are therefore fundamentally wrong and overly optimistic.

The above graph, indicating the typical pattern of expenses increasing faster than income for income properties, was originally intended to be part of my book (see sidebar) for the Appraisal Institute, but was not allowed by the editors, as the Appraisal Institute maintained that income and expenses increase at the same inflation rate over the long run. This was in 2011.

Nowadays, in year 2025, the truth is increasingly taught by appraisal educators and real-life managers at major firms, but some appraisers have not yet caught on because they were taught wrong earlier in their careers.

A building is a deteriorating asset. There are two forces governing expense growth – price inflation and increasing maintenance and capital improvement needs. This places the rate of expense growth higher than price inflation alone. This is the same reason that your new car depreciates so quickly.

Why is this matter so important? Most DCF models project 11 years of cash flows, and the underestimation of expense growth gets compounded, resulting in serious overvaluation.

One of my fellow Appraisal Institute authors, Howard Gelbtuch, assembled and edited an enlightening book in 2011 entitled Real Estate Valuation in Global Markets, in which highly decorated appraisers and valuers from many nations explained how real estate valuation is done in their countries. Once again, most who presented DCF models had final year operating expense ratios lower than beginning expense ratios. Many of the violators were Western nations that are considered financially sophisticated. Nations getting it wrong were:

Belgium, Canada, Czech Republic, Denmark, France, Germany, Hong Kong, Italy, New Zealand, Poland, Portugal, Saudi Arabia, Spain, Sweden, Taiwan and Turkey.

Which nations got it right? Nations less likely to be considered part of the supposedly sophisticated Western herdthink:

Argentina, Bulgaria, Chile, Indonesia, Japan, Romania, South Korea, and the Turks and Caicos Islands.

Getting beaten by the likes of Bulgaria in DCF analysis should shame appraisers and valuers from the more affluent Western nations into "stepping up their game", if they haven't already done so.

Even the author of the book, who wrote the section on appraisal practice in the United States, failed to consider increasing operating expense ratios in his own DCF projection, in which his operating expense ratios remained stationary. Bear in mind though, that this book reflected appraisal practice at the time it was written in 2011.  Time for an update?

PS: I originally wrote this post in 2014.

My Part in a Successful Arbitration Against a Sovereign Nation

 

No, this is not about the Korean situation I was handling before, in which the Municipal Government of Seoul underpays property owners in an out-of-control eminent domain system.

There are actually sovereign nations within the United States of America, known as Indian Reservations.

By U.S. law, Indian Reservation land cannot be sold to outsiders, so to have some type of real estate interest on the reservation, the outside investor needs to lease the land, and the ownership interest is called a “leasehold interest”. This is how one obtains a valid real estate interest on an Indian reservation or elsewhere such as Hawaii or the Zona Maritima in Costa Rica. This is often done on Indian reservations by developers of gambling casinos, for instance.

In this particular case, a client of mine wished to build an industrial park on an ideally located section of an Indian Reservation, and then he divided the proposed park into pieces to lease out to three willing outside tenants. What he possessed, as a leasehold landlord, is commonly known as “sandwich leasehold interests”. He pays rent to the Reservation, but in turn was already collecting rents from 2 of the 3 tenants who want to develop buildings on the property that he leases from the Reservation. It was a very profitable arrangement.

The Reservation changed their mind and broke their contract after my client had spent 5 years and over $2 million assembling this deal. Contract disputes with Indian reservations are typically handled by Arbitration as typically established in contracts such as these.

I was hired to estimate the value of the leasehold interest as of the date of the breach of contract in August 2020. Tens of millions of dollars were already expected in rents. The irony of this breach of contract is that my client agreed to divide profits with the reservation at 50%.  At present, no one is making any money except lawyers and me.

My client has won the arbitration but is now awaiting the computation of the award and damages.

P.S.  Here is my Oklahoma grandfather, who I am named after, who claimed to be part Cherokee. That is a Kiowa war bonnet that he is wearing. The Cherokees renounced war in their treaty with President George Washington, in turn for his declaring them a "Civilized Tribe".

What Isn't Said About Living and Owning Real Estate in Costa Rica

 I have been appraising in Costa Rica since 2009, and have usually found myself appraising failed residential subdivisions meant for affluent immigrants from North America.  Then there were teak farm scams, too. 

There is a huge industry aimed at selling Costa Rican real estate to North Americans, exemplified by such publications as International Living and Real Estate Trend Alert [Ronan McMahon]. It is important to remember that these are sales organizations which present only the positives of living in Costa Rica, a land of natural beauty sometimes described as "the land of rainbows and unicorns". And it is not true, despite what Ronan says, that Costa Rica is running out of land.

Yet many Americans return disappointed from Costa Rica.  There are no official numbers.  Unofficially, I have heard estimates that between one-third and one half of American immigrants return home from Costa Rica. There are an estimated 120,000 Americans living there now.

Yesterday I watched a podcast on MSN.com by Kristin Wilson, an international realtor who lived in Costa Rica for 8 years and only recently came back home, and she compiled a list of 8 reasons why Americans return, and some of these reasons I have also observed, but I haven't actually lived there so I encourage you to watch the podcast. You can find her full report at: 

https://www.bing.com/videos/riverview/relatedvideo?q=kristin+costa+riica&mid=9D793F3EED243527C1269D793F3EED243527C126&FORM=VIRE

Here are some added comments of my own on the reasons Americans leave:

1. Cost of living. First of all, living in tropical lowlands requires year-round air conditioning if one wants to live in American-style comfort, costing several hundred dollars per month. Most goods also have to be imported and Costa Rican tariffs are high. It will cost more to own a car in Costa Rica than in the U.S. If wants to live the US standard of living, there may be no cost savings and perhaps even some cost surprises.

Costa Ricans often live a lot more cheaply by living in small homes at higher elevations.  Below, for instance, is a realtor ad for a "Tico Home" in the uplands of Guanacaste, perhaps the physically hottest area of Costa Rica (temperatures near 100 degrees F when I visited in February).  These are simpler homes that are built from local materials and don't typically have air conditioning or heating, but at higher elevations, such utilities might not be necessary. But it might be a long walk to the beach, and where will you find a Wal-Mart?

2. Crime. Official crime statistics suggest that Costa Rica is a nation with a low crime rate, but one forgets that being a rich gringo can make one a target. Reading expat forums, I sometimes read alarming things like "I got robbed at gunpoint in broad daylight on the National Highway!", police shakedowns of tourists, and there have been many reports of how gringos are followed by robbers after renting their car at the airport, particularly after dark. Kristin also chronicles her many car break-ins and one or more home burglaries, and carries around a decoy wallet.

3. Health issues.  This seems surprising when one sees the number of hospitals near the Liberia and San Jose airports, hospitals built for North Americans wanting to save money on medical or even dental procedures, and I have been assured that most of the doctors are English-speaking and U.S.-trained. One notices, though, that these hospitals often focus on elective surgeries, those not covered by insurance, such as cosmetic surgery.

Considering that many of the expats are retirees, though, one has to plan for increasing health problems in the future.  U.S. Medicare is not available down there, and end-of-life health issues can force Americans to return home for seriously expensive situations such as cancer, heart surgery, etc.  I went through cancer last year and was glad for my Medicare here in the U.S.. 

4. Unstable infrastructure.  This may include power outages, cable outages, water outages, and impassable roads during rainy months.

5.  Property scams.  The first time I heard about this, it was a friend of mine who sold his business and arranged to purchase a cliffside home and restaurant through a local lawyer. The lawyer was corrupt and was working a scam with someone who didn't even own the property. In another instance, I had an American absentee landowner find his properties occupied by squatters, and he spent several years fighting to get his property back in the Costa Rica courts, which often honor squatter's rights over the rights of foreigners who are not even using the land. The squatters' lawyer was allegedly building and renting billboards on the land.

Get a title insurance policy if you possibly can, too. My friend lost over $100,000 and had to go back to work in the U.S.

6. The climate speaks for itself. These are the tropics and there can be plenty of heat, humidity and rain which some Americans don't care for. Costa Rica is outside the hurricane region, however.

7. Finally, some expats just feel the isolation from family and loved ones living so far from the U.S. and reprioritize what they find more important in life -- family or beaches?

Depth Matters: Appraisals of prospective ports

Bahia de Mariel, Cuba

Over the years I have sometimes been sent to the Caribbean to appraise proposed ports for cruise ships or container ships. Other appraisers failed to pursue feasibility studies, but there are some basics that need to be considered.

First and foremost is the depth of the water.

Today’s cruise ships have drafts (distance below the water) of up to 33 feet. Think Royal Caribbean.

Container ships are much heavier (due to cargo rather than vacationers) and have drafts up to 50 feet.

Then one must consider obstacles on the sea surface, such as boat wrecks or just abandoned refrigerators. American shippers estimate an extra 6 feet for these obstacles. Russian sailors recommend 7 feet.

When I worked for hard money lenders, I sometimes had to deal with jokers who pretended that their bays could be converted to world class cruise ship ports or even cargo ship ports, with accompanying warehouses or luxury resorts.

One particular memory was Guanica Bay, Puerto Rico. Read the original blog post here:

https://www.internationalappraiser.com/search?q=puerto+rico

The gist of the story is that Guanica Bay had a depth of only 29 feet, which was an obstacle to the larger cruise ships. Subtracting 7 feet reduces maximum draft to just 22 feet. The turbidity of the water, furthermore, reduced the attractiveness of the proposed beach resort.

Cuba recently renovated its Mariel Bay (remember the Marielitos emigration of 1980) at a cost of more than one billion dollars (financed by Brazil) to create an internationally competitive port, so near the U.S., with a minimum depth of 58 feet.  A century ago this bay had an average depth of less than 20 feet.

In summary, depth matters, water quality matters, and be sure that all the required permits are in place, no matter what country you are in.

Update on the New South China Mall

I do see one person now, who appears to be a groundskeeper, standing to the right of a yellow object.

In the 15-year history of my blog, my previous post from May 2011 on this mall https://www.internationalappraiser.com/search?q=china+mall has been read more than 50,000 times.  The gist of the story was that a Chinese instant noodle billionaire decided to build the world's largest mall outside Dongguan, China. With over 9 million square feet of building area, he was planning on placing 2350 tenants. At the time of my arrival on 5/13/11, there were three tenants: KFC, McDonalds, and Kung Fu, a Chinese fast food franchise. There was also an amusement park set among hundreds of meters of canals, and on the day of my visit, it was filled with several dozen friendly secondary school students.

As I explained then, the mall was built on farmland near a city composed mainly of poor migrant laborers who built cheap cabinets, shelves and furniture, people who did not have the time or money to be mall shoppers. Access was inadequate. The Dongguan rail station was 55 minutes away and the closest bus station was one mile away.  There were tollways leading here, but the local residents could not afford the tolls or even cars. A recent YouTube video (shot in 2024) by a charming British couple (aka NICO), confirmed that there is still no public transportation to this mall. See their guided tour at https://www.youtube.com/watch?v=gyS_ZNkSTOA .

The mall has suffered for years. Once adorned with beautiful canals reminiscent of the San Antonio RiverWalk in Texas, the inability to control algae growth forced the decision to fill in the canals with concrete.

Development continued in 2015 and then 2018, and the mall was able to achieve greater than half occupancy on the ground floor:

On the other hand the upper floors continue to fail to lease up:

And the amusement park that attracted so many middle class Chinese customers has recently shut down:

Now that local factories are closing due to economic reasons (cheaper competitors and Trump tariffs), there may be more headwinds against this enormous shopping mall.

Mall management claims an occupancy rate of 98%.  Based on the photos my estimate is 15%.