Kariya, T., Ohara, H. and Honkawa, T. (2002)
A Dynamic Discounted Cash Flow Method for Valuation of an Office Building

abstract

This paper proposes a framework and an associated dynamic model for valuing a rental real estate such as an office building as a discounted cash flow (DCF) value of future rents. The future rents are uncertain and described as a stochastic process. Hence the DCF value is also a random variable having a DCF distribution, which we call DDCF (dynamic DCF) distribution. In other words, the value of a rental real estate is in fact the distribution of all possible DDCF values, from which the mean of the DDCF distribution is obtained as a value of the building with a risk measure. Our valuation model in this viewpoint is different from the traditional static DCF valuation model in that we directly treat the dynamic risk or uncertainty factors that stochastically change the patterns and sizes of rental cash flows. Hence the problem of determining on cap rate or risk premium, which is a big issue in the valuation of a real estate by the traditional DCF method, is decomposed into the problem of determining a gfairh trading value of the real estate and the problem of valuing or measuring the risk as an uncertainty of the fair value. This decomposition naturally fits the framework of the traditional portfolio analysis and enables us to include real estates in an investment or financial analysis. Various simulations demonstrate a descriptive capacity and effectiveness of our valuation model. In addition, a valuation model using a real option, which is given as an exit strategy for selling out real estate, is formulated as an extended DDCF valuation model.

   

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