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.