The Discounted Cash Flow That Didn't Add Up
A client provides you with a DCF for a 10-year hold of a R95 million industrial property. The model shows: net operating income year 1 of R8.5m growing at 6% p.a.; exit at year 10 capitalised at a 7.5% cap rate on year-11 NOI; discount rate 11%; terminal sale costs 2%. The client's spreadsheet produces a value of R142 million and they want you to 'confirm' it for an investor pack. On checking, you notice: (a) NOI growth of 6% exceeds the discount rate's implied inflation; (b) the exit cap rate (7.5%) is below the going-in cap rate (8.5m/95m ≈ 8.9%); (c) no capital expenditure or leasing costs are deducted; (d) the discount rate is applied to NOI, not to cash flow after capex.
1. Identify the errors in the DCF and explain their directional effect on the R142m figure.
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Error (a) - Growth vs discount rate. NOI growing at 6% while discounting at 11% implies real growth of ~5% (if inflation ~1–2%) - implausibly high for industrial NOI long-term. Overstating growth inflates the terminal NOI and the PV of the cash flows → overstates value.
Error (b) - Exit cap below going-in cap. A 7.5% exit cap on a property bought at ~8.9% implies cap compression (yield falls) over the hold - i.e. the model assumes the asset gets more expensive per rand of income. That is a bullish assumption that inflates the exit value. Unless there is strong evidence of sustained yield compression, exit cap should be at or above the going-in cap (reflecting depreciation/risk). This overstates the terminal value and hence value.
Error (c) - No capex or leasing costs. Real industrial assets incur capital expenditure (roof, HVAC, resurfacing) and leasing commissions/tenant incentives. Omitting them overstates net cash flow and value.
Error (d) - Discounting NOI, not cash flow. The discount rate must be applied to cash flow after capex and leasing costs, not gross NOI. This overstates PV.
Net effect: All four errors push the value upward. R142m is almost certainly overstated; the true value is likely closer to the R95m going-in level (or below, depending on capex).
2. Describe how you would correct the model and what figure/range you would present, and how you would communicate this to the client.
Read the worked answer
Corrections:
- Growth: set NOI growth to a defensible long-term rate (e.g. inflation-linked, 2–4%), with market evidence.
- Exit cap: set at or above going-in cap (e.g. 8.9–9.5%), reflecting age/depreciation, not compression, unless evidenced.
- Capex & leasing: deduct a realistic annual capex reserve (e.g. 1–2% of value or per m²) and leasing costs/incentives at lease events.
- Discount base: discount free cash flow after capex and leasing, not NOI.
- Terminal costs: retain 2% sale costs; check they apply to gross exit value.
- Sanity check: cross-check the DCF against the direct capitalisation of year-1 NOI at the going-in cap (R8.5m / 8.9% ≈ R95.5m). A DCF wildly above the cap-rate cross-check signals error.
Figure/range: Present a corrected value likely in the R90–100m range, with sensitivity to exit cap and growth. Give a range, not a single number.
Communication:
- Do not 'confirm' R142m. Explain, in plain language, that the model embeds optimistic assumptions and omits costs.
- Provide a reconciliation table: client's R142m vs corrected R~95m, showing each adjustment's rand effect.
- State clearly that you cannot support the R142m for an investor pack; offer the corrected figure with assumptions.
- Protect independence: if the client insists on R142m, decline to attach your name and document why. This is a professional-integrity issue, not just a maths one.