Real Estate, Asset and Business Valuation by Income Approach: Modern Techniques

Abstract

For over two centuries, the income approach has been considered one of the most powerful and reasonable tools for income property appraisal (i.e. real estate, asset and business valuation) or for real estate-related investment project management. The first in time of its emergence to implement the income approach was the direct capitalisation method used in the 19th century. In the direct capitalisation method, simple analytical expressions are used that can be easily developed, e.g. the inclusion of a constant increase in income (Gordon method). About a hundred years ago, the direct capitalisation method began to be supplemented and subsequently replaced by the discounted cash flow method, or DCF analysis. The author of the DCF analysis should be Fisher, who introduced the concept of net present value based on discrete cash flow and constant discount rate. Later, it was supplemented by Solomоn with the important idea of terminal value, also interpreted as capital reversion, final return on capital, or final sale. The recent global financial crisis has increased the investor's attention to the valuation of capital subjects of income property and business with values in use instead of values in exchange, primarily market value. In these cases, the DCF method is the basis for the calculation. The paper discusses the problematic aspects of the valuation of a real estate or a related investment project using the DCF method. First, well-known expressions of DCF analysis were refined in the case of the discount rate variability. Further, previously unknown exact formulas of the DCF method with a variable discount rate and different patterns of cash flow (discrete, continuous and discretecontinuous) have been obtained. Applying derived exact formulas may reduce calculation errors from using traditional expressions with constant discount rates and discrete cash flow.