The DCF Method: If Used Carelessly, Your Answer Will Be Off by 30%. 3 Pitfalls I Fell Into

When calculating the income-based price of real estate, there are quite a few situations where the DCF method is used.
It's that method where you discount future cash flows to arrive at the current price.

You build a model in Excel, plug in the numbers, and get a plausible-looking answer. It comes out, but I have been burned several times in the past by trusting those 'plausible-looking answers.' Moreover, when I checked the calculations later, they were off by 20-30% compared to numbers rebuilt with correct assumptions.

The structure of the DCF method itself isn't that difficult. However, the answer fluctuates wildly depending on how you set your assumptions. This time, I'll write down the three pitfalls I actually fell into. I hope this helps others avoid making the same mistakes.

Pitfall 1: Fixing the discount rate at 'somehow 5%'

I think the first wall you hit when calculating with the DCF method is setting the discount rate.

The Ministry of Land, Infrastructure, Transport and Tourism's Real Estate Appraisal Standards suggest multiple approaches for determining the discount rate, such as 'comparison with transaction cases of similar properties,' 'a method derived from the discount rates related to borrowings and equity,' and 'a method that adds the individuality of the real estate to the yield of financial assets.' In other words, there isn't just one correct answer.

What I did at first was the pattern of searching for 'real estate DCF discount rate' online and adopting the information that came up—'roughly 3-5%'—just as it was. Regardless of the property's location or grade, I just used 5%. Whether it was a new reinforced concrete building in the city center or an old wooden building in the countryside, it was all 5%.

To show how reckless this is, a mere 1% change in the discount rate can cause the DCF valuation to fluctuate by 10-30%. If you set it up for a 10-year holding period, a 1% difference compounds, so the divergence widens in the later years.

Once, when I ran the same property with discount rates of 4% and 6% respectively, I broke into a cold sweat when I saw a difference of over 25% in the income-based price. A calculation without a basis for the discount rate is the same as having no conclusion at all, even if it looks like one.

Now, I refer to the discount rates disclosed in J-REIT appraisal reports as a benchmark for similar properties. I pick 3 to 5 properties with similar areas, building ages, and uses, and decide within that range while taking the individuality of the target property into account. It's not perfect, but it's much better than 'somehow 5%'.

Pitfall 2: Underestimating the destructive power of the reversion price

The income-based price in the DCF method consists of the 'sum of the present value of net income during the holding period' + 'the present value of the reversion price (assumed sale price)'.

What is easy to overlook here is the ratio that the present value of the reversion price accounts for in the total. In one calculation example, the present value of cash flow during the holding period was about 23% of the total, while the present value of the reversion price was about 77%. In other words, about 80% of the number that comes out of the DCF method depends on 'how much it will sell for in the future'.

The reversion price is usually calculated by dividing the net income of the year following the end of the holding period by the terminal cap rate (final capitalization rate).

To clarify the prerequisites, for example, if the holding period is 10 years and the assumed net income for the 11th year is 5 million yen. If you set the terminal cap rate at 4.5%, the reversion price is about 111.11 million yen. If you set it at 5.5%, it's about 90.91 million yen. A difference of just 1% moves the price by 20 million yen. Moreover, since this figure accounts for 70-80% of the entire DCF, the impact on the final income-based price is quite significant.

My failure was that while I was nervous about the discount rate, I set the terminal cap rate casually, thinking, 'Well, it should be about the same as the discount rate.' According to appraisal standards, the terminal cap rate is set based on the capitalization rate at the time of valuation, incorporating market trends at the end of the holding period and the uncertainty of future income fluctuations. Even though it is a different concept from the discount rate, there was a time when I was lazy and just entered the same number.

I think the reversion price is 'a number that has the biggest impact but is often set with the most ambiguous assumptions.' If you treat this carelessly, the reliability of the entire DCF collapses.

Pitfall 3: Dragging out cash flow with 'status quo' for 10 years

The third point is about cash flow forecasting during the holding period.

In the DCF method, it is necessary to forecast the net income for each year of the holding period (usually 5-10 years for real estate). And at first, I just copy-pasted the first year's net income for all 10 years. The vacancy rate, expense ratio, and repair costs were all the same as the first year.

In reality, repair costs increase as a building ages. Air conditioners and water heaters need replacement every 10 years or so, and exterior wall painting and rooftop waterproofing also have their own cycles. There are also property tax reassessments. Restoration costs and rent-free periods associated with tenant turnover cannot be ignored in the long term.

For example, suppose a property with an annual net income of 5 million yen incurs 1.5 million yen in major repairs in the 5th year and 1 million yen for replacing all air conditioners in the 8th year. Whether or not you factor this in changes the total cash flow during the holding period by 2.5 million yen. Even when discounted to the present, it results in a difference of around 2 million yen.

You might think, 'If the reversion price accounts for 70-80% of the total, the cash flow during the holding period is only 20-30%, so isn't it okay to be a bit sloppy?' I used to think that too. But missing repair cost estimates affects not only the cash flow but also the assumptions for the reversion price. A property where repairs have been postponed at the end of the holding period will be priced by the buyer to include the risk of those repairs, so the terminal cap rate may shift upward.

Ultimately, sloppiness in cash flow leads to sloppiness in the reversion price. If you cut corners here, the error is amplified in combination with Pitfall 2.

Now, I allocate repair costs year by year based on a long-term repair plan (or my own rough estimate if one doesn't exist). I also fine-tune the vacancy rate year by year based on area supply and demand trends, rather than just using the 'current' rate. It takes time, but I believe that if you are going to use the DCF method, there is no point in cutting corners here.

Looking back, the one thing all three pitfalls have in common is that I set the assumptions carelessly. The DCF method is a technique with as many 'dials to turn' as there are assumptions, and if you turn those dials randomly, the answer can easily fluctuate.

The solution I arrived at is simple but effective: run a sensitivity analysis as a set. By shifting the discount rate and terminal cap rate up and down by 0.5% each, I can grasp the range within which the income price falls. It is more useful for decision-making to present it as 'falling within a range of X yen to Y yen' rather than saying 'the answer is Z yen'.

The DCF method is an excellent tool, but the numbers can move however you want depending on the user's assumptions. The scariest thing is to use it carelessly and get the feeling that you have done a 'precise analysis.' A note to myself.

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