Valuing Case using DCF

7. Case: Greve Distribution Center

Figure 30 Opportunity Cost of Capital tree

We can now use the opportunity cost of capital calculated to quantify the amount of risk there is embedded in the GDC project relative to the risk premium required for already built properties in general by using the following formula:

𝑂𝑂𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝑚𝑚𝐶𝐶 − 𝑃𝑃𝑓𝑓

𝑃𝑃𝑣𝑣− 𝑃𝑃𝑓𝑓 =26.93%−0.375%

7.2%−0.375% = 3.89

The GDC development project is an investment with an embedded 3.89 times higher risk than com-pared to an unlevered investment in a completed property. It is important to notice that the higher risk embedded in the project is in relation with a higher return than the average property market. In order to carry out our analysis of the GDC project fully, we also analyze the project by applying a discounted cash flow valuation approach.

7. Case: Greve Distribution Center

estimated net operating income estimated as 590 DKK pr. Square meter for the phase 1 building and phase 2 building and all other parameters that is not depended on the valuation methodology.

The key component in the discounted cash flow approach, which would vary depending on the valua-tion methodology is the discount rate applied. One could argue that the discount rate should be equiv-alent to the opportunity cost of capital identified in the previous section, but this is likely not to be the case in practice as it would require doing the rigorously option pricing methodology performed in this thesis in order to estimate that number. Geltner states that the discount rate used for real estate development projects back that was used back in the 2000´s was around 20% p.a. His justification for this number is fairly week as they suspect this is due to the number being nice and round and in con-sistent with the conventional wisdom for required returns (Geltner et al. 2013). However, recall that we stated earlier in this thesis in section 5.2.5 that the discount rate should be calculated for each cash flow in accordance with its individual embedded risk. If we were to follow that theoretical logic, we would likely not apply the same discount rate used for calculating the value of the phase 1 building and phase 2 building. Numerous reasons support this point. First there is the time to build. The phase 1 building could be completed within a year versus the phase 2 building can at the earliest be com-pleted in 2 years. In general, it can be assumed that uncertainty increases the further we look out in time. As a result, our predictability of estimating the actual value of the phase 1 building at t1 is higher than for the phase 2 building at t2. This implies that a lower discount rate should be applied when estimating the value of the phase 1 building.

Secondly there is the size difference of the two buildings. Recall that the phase 1 building consisted of a total of 40.000 square meters and the phase 2 building consists of 60.000 square meters. This im-pacts the vacancy risk associated with the building. Naturally the vacancy risk increases with the num-ber of square meters in a building, due to the need of a higher market demand in order for the building to be fully rented. This also implies that the discount rate used when estimating the value of the prop-erty today should be lower for the phase 1 building.

Estimation of the appropriate discount rate for each building. One approach to do this could be the bottom-up- approach. Here the risk-free rate is identified as the base rate for the discount rate, this could be equivalent to the already established discount rate used in this thesis as the 10-year Danish government bond effective yield. The next step is to identify all the different factors that could poten-tially impact the net operating profit of the building in a negative way, and assign a risk premium for each factor. These factors could be things such as legislation, vacancy risk, liquidity risk, business risk

7. Case: Greve Distribution Center

premiums are added on top of the identified base rate and sum amounts to the appropriate discount rate. However, it is immensely challenging to estimate the risk premium for each factor making the approach difficult to apply. Another approach is looking towards the market and use the discount rates for similar projects. Due to the real estate industry being of somewhat private and closed, data availability is likely not be the case making the approach near impossible. One approach we have not touched up is the one asking a more experienced person for a discount rate and trust that their gut feeling is better than yours. David Geltner is such a person and therefore we trust that the appropriate discount rate for real estate development projects is 20% as he suggested. However, we modify this by making it an average discount rate for both projects by using a discount rate of 15% for the phase 1 building and 25% for the phase 2 building. This ensures that we are in accordance with the theoret-ical understanding that the risk is lover for the phase 1 building, which should be reflected in the dis-count rate.

Figure 31 DCF calculation of GDC

The above figure shows an NPV of 5.32 mDKK and an IRR of 23.46%. In the calculation we have used the land option value calculated using the real option pricing approach. Even though the found land value is used the DCF methodology still gives an NPV >0, which indicates that the applied discount rates of 15% and 25% is to low resulting in an overestimate in value, when compared to the embedded OCC of 26.93%. Obviously, this is looked at from an economical theoretical point of view assuming market equilibrium as in the real option pricing methodology. However, in the real world the assump-tion of an efficient market in the real estate development industry is most likely not the case as land is not purchased at it´s given option price.

The Traditional DCF

Time 0 1 2

Discount rate 15% 25%

Land price 269.60 Phase 1 Building

Value 416.06

Construction cost (265.72) Phase 2 Building

Value 632.65

Construction cost (407.35)

CF (269.60) 150.34 225.30 PV (269.60) 130.73 144.19 NPV total 5.32

IRR 23.46%