Comparison of the DCF and German income approach

Introduction

Property valuations play a key role in the real estate market and are used for a variety of reasons, such as purchase and sale decisions, mortgage lending, pricing of shares, insurance premiums or taxes. Their most common use in the real estate investment universe is as proxies for market prices (Baum, 2009). Due to the peculiarities of real estate, property values are not readily observable on the market and valuations are used as surrogates for transactions that did not take place.

There is an ongoing debate around the traditional German income approach (GIA) of property valuation and internationally applied methods such as the discounted cash flow (DCF). In Germany, the majority of institutional investors uses the traditional valuation method known as Ertragswertverfahren (literally translated as earnings-value-technique) while investors abroad rely on DCF approaches. This paper represents the first large-scale empirical comparison of the two methods under the same conditions. So far, research into the GIA has remained largely theoretical and the few existing empirical analyses lack suitable comparisons. Due to an increasing number of German investors employing DCF appraisals, it was possible to compare the two methods directly under the same market conditions. The objective of this paper is to investigate how German valuations according to GIA differ from German DCF valuations and to add empirical insights to the ongoing debate between mostly German proponents and mostly international opponents of the GIA.

In the next section, the two valuation methods are explained followed by a summary of existing literature. Thereafter, the data are introduced. The analysis consisted of a simple performance comparison followed by hedonic regression analyses based on ordinary least squares (OLS). Fitted GIA and DCF values were obtained for all observations in the data set. This way, distortions due to underlying property characteristics were eliminated. The paper closes with a conclusive summary.

Income-based valuation techniques

The majority of property valuation techniques can be divided into three categories: cost approach, comparison approach and income approach. Even though all three methods are used internationally, they can differ considerably in their application (Downie et al., 1996). Both, the GIA and the DCF, are income-based approaches, deriving a property’s value from the income stream it generates.

Even though DCF style valuations are widely applied internationally,...