I was commissioned to value an income generating property, a resort hotel for financial reporting purposes. The property is income generating, thus I am aware that I should employ income approach in order to get the market value of the property. I asked the owner for the income statement and interviewed key personnel on the sources of income and expenses of the hotel.
Based on the experience, property owner will always ask for the true value of their properties that generates income. The investor on the other side, is less concerned about the actual physical property than the income stream it will generate in the economic life of the property.
In applying income approach, an appraiser will choose between the two basic methods. One is the Discounted Cash Flow Method and second, the direct capitalisation method that uses cap rate as helpful tool in converting cashflow into property value.
Discounted Cash Flow Analysis (“DCF”) is the foundation for valuing commercial real estate. The value of an asset is simply the sum of all future cash flows that are discounted for risk. Since the forecasted revenues and expenses vary from time to time, cap rate won’t be an accurate gauge to determine value of the property.
The hotel is in its early years, thus the revenue it generates remains small (35%) in compare to its potential gross income. However in appraisal, it is important to generate the potential income of the property, its optimum use, and proceed to cash flow analysis. This should be in accordance with the growth projection of the industry or the economy. Next, we have to reconstruct the income statement to check if which figures to use, verify or eliminate.
The most important part in DCF Method is how to determine the discount rate. It should answer the return on risks that motivates the investor. The timing of the future cash flows it will generate and the likelihood that it will occur greatly influences the investor’s willingness to pay for an asset today. Riskier cash flow streams are discounted higher rates, while more certain cash flows are discounted at lower rates.
Our valuation of the hotel indicates different value estimate. Income approach thru discounted cash flow is higher by 15% in contrast to cost approach. DCF analysis is the most comprehensive method utilised to evaluate all of the risk factors that are considered in commercial valuation. As a valuer, we understand the weight of an approach to value better than most.