constructing the dcf

Those land use options which appear, prima facie, to be economical are analyzed further using 
discounted cash flows to determine the feasibility of the project or land value. The construction of a 
DCF requires firstly, the construction of a cash flow in the same order as the monies are expected to be spent. 
The cash flow for a land development project can be considered in 3 broad stages:

• 	Purchase and transfer of the land into the developer's name

• 	Construction of the buildings, roads subdivision etc

• 	Determination of end market value and selling costs.

PURCHASE OF LAND

The purchase of land incurs the following extra expenses:

• 	Legal on purchase

• 	Stamp duty

Therefore, the cost of land in the purchaser's name is higher than the purchase price.

CONSTRUCTION COSTS

Construction costs are:

• 	Council approval fees

• 	Consultants' fees

• 	Progress payments to builder

• 	Holding charges.

Consultant fees are mainly for the architect and engineer - see appendix A. Progress payments are 
payments made to the builder and approximate the "S" curve - see diagram 2-1. That is, the larger payments 
are made during the middle of the construction period.

Holding charges are property taxes paid during the development period. 



See construction period


SELLING COSTS

Selling costs are legal on sale, agent's commission, and advertising and promotion.


END MARKET VALUE (EMV)

The end market value (EMV) is the expected value or sale price of  the project on completion. 
Depending on the type of the proposed building one of the following methods of valuation is used:

IF THE PROPOSED BUILDING IS TO BE LEASED OUT

That is, an "investment"  property and therefore, is valued with the capitalization method:

	MV = AI * 100/CR

	Where:

	MV = market value
	AI = net annual income
	CR = capitalization rate as a percent

For example, if the expected net annual income is 40 000 per annum, the  market value at 8% 
capitalization rate is :

	MV = 40 000 * 100/8 = 500 000

IF THE PROPOSED BUILDING IS TO BE OWNER OCCUPIED

For example, a block of strata units to be sold to purchasers who will live in the units, the in line method 
of valuation is used. 

SALE OF A GROUP OF BUILDINGS

If the project is the construction of rowhouses (terracehouses), townhouses or free standing cottages the 
end market value is determined by the direct comparison method of  valuation. This is best done by  
directly comparing the expected project properties with recent sales of comparable properties in that 
locality.

FEASIBILITY EXAMPLE

A block of residential land is suitable for the construction of density development.  After considering a number of different possible land uses using the design factors covered in modern design and legal controls, it is found that the most probable highest and best use is for 3 row houses.

PROJECT DESIGN

The local town plan and building controls are analyzed to determine the maximum allowable development. 
These controls can vary greatly between local government areas and state to state. However, there are 2 
trends in development control which are making such controls more universal:

• 	Use of discretionary powers by councils

• 	The Federal Government's attempt to implement a national code for development control. 
  

• - Australian Model Code for Residential Development: Urban (Amcord Urban).

THE PROJECT

COUNCIL DISCRETIONARY POWERS

The trend is for councils to have flexible development controls by way of discretionary powers 
under which they can waive measures and guidelines in  favour of a "performance approach". The 
performance approach method allows councils to approve innovative  and novel developments which would 
otherwise run counter to standard form development codes for example, to meet the objectives of "urban 
consolidation".

The Amcord Urban recommendations recognise the need for such flexibility and has already been adopted by a 
number of councils around Australia. The trend away from easily measured and quantifiable measures makes 
design of the project more difficult for the valuer and more expertise and consideration of good design 
criteria are now required. If the valuer does not do this he/she may not properly determine the "highest 
and best" use of the site and therefore, would arrive at a wrong land value or wrong feasibility decision.

After considering the legal and physical controls based largely on the design principles in part 2 density 
residential is considered to be the highest and best use. The local town plan and building code is analyzed to 
determine the allowable maximum number of residential units which can be constructed on the site. 
This is found to be 3 rowhouses to be sold to owner occupiers on completion and  is reinforced by inspecting successful developments nearby. 

The first step in the construction of a discounted cash flow is the construction of the cash flow.

CONSTRUCTING THE EXPECTED CASH FLOW

The expected cash flow for the above development is as follows:

	CASH FLOW FOR A RESIDENTIAL DEVELOPMENT SITE: 

	Land area:					900 m2
	Project to build s row cottages:
	Cost per cottage:				66 000
	Ground improvements/ carpets and 
	extras per cottage:			         6 000




TABLE 1
THE PROJECT'S EXPECTED CASH FLOW

                                                       QUARTERS:'000

ITEM	

0	

1	

2	

3	

4	

5	

TOTALS

CONSULTANTS' FEES		

(0.35)	

	(2.10)	
      

	(3.10)
      

(3.30)

(1.05)	

(9.90)

CONSTRUCTION COSTS:	

Building 1			

(2.00)	

(4.00)	

(20.00)

(30.00)	

(11.00)

(1.00)	

(68.00)

Building 2				

(1.00)	

(12.00)

(18.00)	

(25.00)

(10.00)	

(66.00)

Building 3				

(2.00)	

(10.00)

(14.00)	

(30.00)

(10.00)	

(66.00)

GROUND IMPS etc:						

(6.00)

	(12.00)

(18.00)

ADVERTISING:						

(0.20)	

(0.40)	

(0.60)

SELLING COSTS:					

(4.80)	

(10.20)

(4.80) 	

(19.80)

HOLDING CHARGES:	

(1.00)		

(1.00)		

(1.00)

 (3.00)

END MARKET VALUE:					 

160.00 

340.00   

500.00

TOTALS:			

(3.00)	 

(7.35)	

(45.10)

(69.90)	 

73.30 	

300.75    

248.7

											

INTERPRETING THE CASH FLOW

Once the cash flow is constructed it should be examined to determine a rudimentary measure of 
economic feasibility. The total of the totals should show at least, a reasonably large positive figure. 
That is, if the total is negative or a small  amount then the project is not feasible and that land use is 
not the highest and best use.

DISCOUNTING THE CASH FLOW

Although the cursory analysis of the cash flow is useful, it is not a detailed or proper analysis as it does 
not take into account the time value of money:   

• 	The real cost of an outgoing in the future is less than the cost of that outgoing today.

• 	A future income or benefit is worth less than that income or benefit today.

The cash flow is therefore discounted at a profit and risk factor or internal rate of return which is 
commensurate with the risk, size and complexity of the development.

PROFIT AND RISK FACTOR

The profit and risk factor used in valuation and feasibility studies consists of 2 parts:

• 	Required return on investment monies

• 	Reward to the developer for his/her entrepreneurial skills and 	inputs.

The courts have considered the profit and risk factor in a number of court cases and the necessity of 
including a discount on net realization to obtain market value before costs. The cases have been concerned 
with profit and risk in the traditional formula for the valuation of in globo lands but the same reasoning 
applies to the determination of a suitable discount rate in Discounted Cash Flow. 

See Turner's case

RETURN ON INVESTMENT

The return on investment is the value of "opportunity cost" investments. For example, in the case study it 
is assumed that the developer is using their own money and therefore, will require at least that rate of 
return. If the opportunity cost of a riskfree investment (eg state government bonds) is 5% per annum, the 
developer will require at least 7% return for the project or investment property.



REWARD FOR THE DEVELOPER

Reward for the developer is a return for their expertise, supervision and control of the proposed development. 
If the development is a pioneer land use, the reward will be high so as to compensate for the high risk 
involved. However, for the example above,  3 rowhouses in this locality is a small and safe development and 
therefore, the developer is prepared to accept a  3% per annum margin as their reward. Therefore, the required 
profit and risk factor for the subject development is:

		RETURN ON INVESTMENT		7% per annum
		REWARD TO DEVELOPER:		3% per annum
							----------------------
		PROFIT AND RISK FACTOR:		10% per annum


DISCOUNT FACTORS (DFs)

The cash flow is discounted using discount factors. A discount factor is calculated for each period as follows:

	DF = 1/basen

	DF = discount factor
	base = 1+ i where i = interest rate as a decimal
	n = discount period

	EXAMPLE
	The discount factor for period 3 or third quarter at 10% per annum (2.5% per quarter) is:

	DF = 1/(1.0253) = 0.9286



RULES FOR GOOD DCF CONSTRUCTION 1

• 	Keep the cash flow as short as possible. Do not use arbitrary  	time spans such as 5 or 10 years.

• 	To help keep the cash flow compact, use multiples of $'000
      

• 	If the expected cash flow is nearly "level" then there is no need for a DCF. 
  

•         A DCF is only used for uneven and complex cash flows.
      

• 	Most cash flows require prediction of amounts in the future. 
  

•            If you cannot predict with reasonable certainty future changes tothe cash flow (eg rent levels) 
  

•            then you must input a level amount. 
  

•            A level prediction is the default cash flow. That is, do not construct cash flows which show 
  

•            increases or decreases because it makes the cash flow "look good".  
      

• 	When DCFs are used to determine "market value", it is the market's forecasts that count, 
  

•            not  the valuer's personal opinion. 
  

•            "Guesstimates" of future amounts are far too dangerous under current liability law.
      

• 	Always remember the purpose of the cash flow. To estimate as accurately as possible all future 
  

•            income and benefits by notionally (on paper) constructing the development. 
  

•            Therefore, there must be necessarily, be large error in such estimates.
      

• 	Because of the high inherent error in most real estate cash flows there is no point in trying to 
  

•            input too much detail or worrying too much about the accuracy of small items such as fees. 

• 	Do not include interest payments in the DCF,  that is, assume that the developer is paying for 
  

•            the development with his/her own money. The logic is the same, because the developer by  using their 
  

•            own money is forgoing interest (opportunity cost of investment). 
  

•            By assuming a cash development, there is less chance of "double accounting" when the cash flow is 
  

•            discounted.

USING THE FINANCIAL CALCULATOR TO DETERMINE NPV

Using Sharp financial calculator notation (eg EL 735):

		To clear all cash flow memories: <RCL>+<CFi> (display: CFi 			SEARCH)
		<2ndF>+<CA> (display: CA CFi? --> ENT

		Enter cash flows in sequence:

		1 <2ndF>+<Ni> (tells the calculator how many equal cash flows 		in a sequence
		-3 <CFi> (display: CF(O), Ni = 1)
		1<2ndF>+<Ni>	-7.35 <CFi> (CF(1), Ni=1)
		1<2ndF>+<Ni>	-45.1 <CFi> (CF(2),Ni=1)
		1<2ndF>+<Ni>	-69.9 <CFi> (CF(3), Ni=1)
		1<2ndF>+<Ni>	73.3 <CFi> (CF(4),Ni=1)
		1 <2nd F>?<Ni> 300.75 <CFi> (CF(5),Ni=1 )

		The NPV can now be found:
		2.5 (discount rate per quarter) <NPV>

TABLE 2
DISCOUNTED CASH FLOW - NET PRESENT VALUE

                                                       QUARTERS:'000

ITEM	

0	

1	

2	

3	

4	

5	

TOTALS

CONSULTANTS' FEES		

(0.35)	

	(2.10)	
      

	(3.10)
      

(3.30)

(1.05)	

(9.90)

CONSTRUCTION COSTS:	

Building 1			

(2.00)	

(4.00)	

(20.00)

(30.00)	

(11.00)

(1.00)	

(68.00)

Building 2				

(1.00)	

(12.00)

(18.00)	

(25.00)

(10.00)	

(66.00)

Building 3				

(2.00)	

(10.00)

(14.00)	

(30.00)

(10.00)	

(66.00)

GROUND IMPS etc:						

(6.00)

	(12.00)

(18.00)

ADVERTISING:						

(0.20)	

(0.40)	

(0.60)

SELLING COSTS:					

(4.80)	

(10.20)

(4.80) 	

(19.80)

HOLDING CHARGES:	

(1.00)		

(1.00)		

(1.00)

 (3.00)

END MARKET VALUE:					 

160.00 

340.00   

500.00

TOTALS:			

(3.00)	 

(7.35)	

(45.10)

(69.90)	 

73.30 	

300.75    

248.7

DISCOUNT FACTORS:	

1.0000	

0.9756	

0.9518	

0.9286	

0.9060	

0.8839

DISCOUNTED CASH FLOWS:		

(3.00)	

(7.17)	

(42.93) 

(64.91)	

66.41	

265.82

NET PRESENT VALUE (NPV) = sum of the DCFs =  

214.22

The above DCF is a much more rigorous analysis of the development project than the simple cash 
flow in table 1. Table 2 shows:

• 	That the NPV is positive and therefore, there is a surplus over and above a return of 
  

•            10% per annum.
      

• 	The NPV appears to be a substantial amount and prima facie, a good return for such a 
  

•            development over 5 quarters.

DETERMINING LAND VALUE

If 10% per annum is considered sufficient return on investment for a development of this size, 
complexity and in this location then the cost of the land component should be 214 220.  
However, this is not the land value (that is, the amount that you would bid at auction for the  site) 
but rather, the value in the developer's name (sometimes referred to as acquisition value). 
To determine land value the following formula is used:

	LV = SV * (100/(100+SD+LP))

	Where:

	LV = land value
	SV = NPV or site value
	SD = stamp duty as a % of the purchase price
	LP = legal on purchase as a% of the purchase price

	If SD = 3.4%
	LP = 0.2%

	LV = 214220 * (100/(100+3.4+0.2))	= 206 776 	say 207 000

If it is assumed that the risk is much higher, say 20% per annum, the DCF must be discounted at 5% 
per quarter to determine the land value which will provide such a return.


RULES FOR GOOD DCF CONSTRUCTION 2

• 	The cash flow is expressed in today's dollars. Therefore, any expected change in value 
  

           should be measured in "real" terms ie, after inflation. For example, if you are using a trend line 

           based on rental evidence over the last 5 years to forecast the expected rents in the cash flow they 

           must be analyzed in today's dollar.
    

• 	During the rent period of an investment building it is unlikely that the forecasted rents will 
  

           reduce because of the ratchet clause in standard form lease agreements. However, after the lease 

            falls due, there is no reason why the expected rents cannot fall in "real terms".

• 	For land use studies 12 months and less: monthly

•             For  land use feasibility studies longer than 12 months:  quarterly 

TABLE 3
DISCOUNTED CASH FLOW - NET PRESENT VALUE DISCOUNTED @ 20%PA

                                                       QUARTERS:'000

ITEM	

0	

1	

2	

3	

4	

5	

TOTALS

CONSULTANTS' FEES		

(0.35)	

	(2.10)	
      

	(3.10)
      

(3.30)

(1.05)	

(9.90)

CONSTRUCTION COSTS:	

Building 1			

(2.00)	

(4.00)	

(20.00)

(30.00)	

(11.00)

(1.00)	

(68.00)

Building 2				

(1.00)	

(12.00)

(18.00)	

(25.00)

(10.00)