Discounted Cash Flow_Operational Commercial Development_Financial Workings (Part 2A)

This section will explain the discounted cash flow method with an example.

Reality Fund (“Fund”) acquired an operational commercial building (“Subject Property”) with a leasable area of approx. 205,500 sft spread across a total land extent of 5 acres in 2018 for a transaction value of $2500 Mn. The subject property is located in one of the prominent commercial markets, which is leased out to various tenants. Now Fund has decided to understand the value of the property as of 30 September 2024 for decision-making purposes. Hence, Fund has reached out to Mr. Joe (“Valuer”) for an assessment of the property.

The role of a Valuer involves assessing the property’s micro- and macro-levels, as well as projecting the future cash flow.

Micro level

The micro level is to understand the property in detail. For better understanding, we will categorize the micro level into property details, rent roll, and financial assumptions.

Property Details

The following table represents the list of major property details required for the assessment. In our example, we have collected from the rent roll shared by the Fund.

• Property Name: “IT Park”

• Land Area: 5 acres

• Structure or number of floors: commercial building with “G+10 Office Floors”

• Number of Blocks: As per the rent roll, we understand that the property has one block, “Block A.”

• Total leasable area: Area that can be leased to tenants. In our example, the area of the property is approx. 205,500 sft

• Car Parking: Average car park size. In our example, we have considered 750 sft as the average car park area (this can vary depending on the location and regulation by the local planning authority).

• No of Car Parks: In our example, the total number of car parks is approx. 274 (total leasable area divided by average car park area).

Rent Roll Analysis

As we understand, the property is an operational commercial development with approx. 80.5% of the area is leased out. Further, based on the rent roll shared by the Fund, we have summarized the rent roll.

• Total Leasable Area: As per the rent roll, we understand that the total leasable area of the property is 205,500 sft. of which
  • Office Space is 200,000 sft
  • The food court or F&B is 2,000 sft
  • Retail (like grocery shops, pubs, and restaurants) is 3,500 sft

• Leased and Vacant Area: of the total leasable area 165,500 sft is leased out to various tenants and the remaining area of 40,000 sft is vacant as of the valuation date

• Occupancy and Vacancy: The percentage of the total area leased out. In our example, the property is leased out approx. 80.5% of the total space and the remaining 19.5% is vacant as of the valuation date   

• In-place Rentals: Weighted average rentals of leased area.

• Weighted Average Lease Expiry (WALE): weighted average period (i.e., from the date of valuation to lease expiry) in which all the existing leases in the property will expire.

Financial Assumptions

In this section, we will discuss the list of financial assumptions required for the assessment.

• Valuation Date: The date on which the value of the property is determined. In our example, the Fund has requested the Valuer to assess the property as of September 30, 2024.

• Exit Period: Date or period when you want to exit the property. As we discussed in the Income Approach section, the projected cash flow would be for a period of 5 to 15 years. In our example, considering the property, we are assuming 10 years will be the exit period, which is 30 September 2034.

• Terminal Cap Rate: Expected yield from the sale of an asset at the time of exit. It is determined by benchmarking similar property sale transactions in the market.

• Transaction Cost: Expenses (Brokerage cost, due diligence, etc.) incurred towards the sale of the property.

• Reserves and Surplus: Reserves or corpus fund created for the refurbishment of the property. It includes renovation of the property, etc., and it will be considered as a percentage of rental income. 

• Asset Management Fees (AM Fees): Fees charged by asset managers for managing the property in terms of cash flow management, leasing, negotiation with lenders and tenants, budgeting, marketing, etc.

Macro level

The macro level is understanding the market assumptions in detail. For better understanding, we will categorize the macro-level into revenue assumptions and cost assumptions.

Revenue Assumptions

Revenue assumptions, including market rent, escalations, CAM income and expense, etc., are determined by benchmarking with similar developments in the market.

• Market Rent: Market rentals for office, F&B, retail, and parking are considered as per in-place rentals.

• Market Rental Escalation: The assumption will be based on historical rental growth in the market. For our assessment, we have considered a year-on-year (y-o-y) escalation of 5%. The following table represents the growth in market rentals.

Note that the above rentals will be used when the existing lease expires and space is available in the market for further leasing. At the time of release, market rentals will be considered as contracted rentals.

For example, one tenant with a leasable area of 10,000 sft expires in October 2025, and the same area is available in the market for further leasing. When the new tenant is occupying the space, it will be leased as per market rent as of October 2025. As per the above table, new rentals as of October 2025 would be $120.8 per sft per month.

• CAM Income: CAM stands for “Common Area Maintenance.” CAM income will be charged to tenants for area maintenance that includes lobby, elevators, cleaning common areas, etc. The CAM income will be determined by benchmarking with similar developments (like similar IT parks, amenities, location, developer profile, age of the building, etc.) in the market.

• CAM Expense: As we have seen above, CAM income is charged to tenants for area maintenance. However, the developer has to incur certain costs for maintaining the IT park or buildings, and the same is called CAM expenses. CAM expenses will be considered based on historical expenses spent by the developer for maintaining the property

• AM Margin: Margin that the developer would make from the property. Margin is derived by subtracting CAM expense from CAM income

CAM Margin ($) = CAM Income – CAM Expense

CAM Margin (%) = (CAM Income – CAM Expense)/(CAM Income)

• Escalation years and Escalation %: Escalation terms for the new leases or vacant leases. For our assessment, we have considered 15% of escalation for every 3 years.

For example, one tenant with a leasable area of 10,000 sft expires in October 2025, and the same area is available in the market for further leasing. When the new tenant is occupying the space, it will be leased as per market rent as of October 2025. As per the below table, new rentals as of October 2025 would be $120.8 per sft per month, and the same will escalate to 15% every 3 years.

Cost Assumptions

Cost assumptions are similar to revenue assumptions. Cost assumptions, including rent-free period, downtime, brokerage, vacancy provision, opex, etc., are determined by benchmarking with similar developments in the market.

• Rent-Free Period: A period during which the tenant does not pay any rent. During the rent-free period, tenants will set up an office as per their requirements, like fit-out works, installing server rooms, etc.

• Downtime: The amount of time it takes to market the vacant area upon lease expiry

For example, one tenant with a leasable area of 10,000 sft expires in October 2025, and the same area is available in the market for further leasing. In order to lease out the property, we have to market the space, and the time it takes for the marketing is called downtime.

• Brokerage: Brokerage or commission paid to third-party consultants.

For example, in the subject property, approx. 40,000 sft of the vacant area is available for further lease. In order to lease out the vacant area, we will hire some external consultants like CBRE and a commission paid to them called brokerage.

• Vacancy Provision: During Operations and Exit: The vacancy provision is to account for the rental loss (like delay in rental payments by tenants) that occurred during the projected cash flow.

Vacancy provision predominantly depends on the existing vacancy of the subject property, demand, and supply in the micro market.

• Insurance Cost: Insurance premium paid towards insuring the property, mainly buildings, plants, and machinery. Insurance cost input will be provided by the developer or client.

• Property Tax: Property tax to be paid to the local authority or to the government. For income generated by commercial assets, property tax will be defined by the government authority. The property tax input will be provided by the developer or client.

• Operating Expense (Opex): Costs that are related to salaries, marketing, and other general expenses. Typically, Opex will be 1% to 2% of rental income.

Projected Cash flow

This subsection covers what typical projected cash flow looks like. Refer to the following sample screenshot of cash flow.

• Economic Occupancy: It measures space or area that is physically occupied.

• Effective Occupancy: It measures the space or area that is generating the income.

• Cash Inflow or Income: Cash inflow or income from commercial developments is as follows, and the same is derived from leases or rent rolls.
  • Rental income,
  • Parking income
  • CAM income
  • Other income, if any

• Cash Outflow or Expenses: Cash outflow or expense from commercial developments is as follows, and the same is derived from leases or rent rolls
  • Vacancy provision
  • CAM Expense
  • Brokerage
  • Opex
  • Property Tax
  • Insurance

• Net Operating Income, or NOI

• Capitalization Value or Terminal Value:

Calculate terminal value or exit value at the 10^th year based on the 11th year NOI

• Other Adjustments: The following are a few major adjustments made to arrive at the net cash flow of the property.
  • Capex or Construction Cost
  • Asset Management Fees (AM Fees)
  • Reserves – Refurbishment
  • Security Deposit – Inflow
  • Security Deposit – Outflow

• Net Present Value (NPV) of property:

Using the XNPV formula, calculate the net present value of the property. Upon arriving at the property, add the NPV of fit-out (if any) and security deposit received from the tenants as of the valuation date.

Refer to the below video for a quick overview of the financial model and workings

Disclaimers

• Assumptions, rent roll, cash flows, etc are for illustration purposes only and do not reflect any actual data
• This financial model is intended strictly for learning purposes and should not be used for any other purpose.