Office Property Appraisal in Milan: Building the DCF Model

Book: Commercial Property Valuation: Methods and Case Studies
Authors: Giacomo Morri, Paolo Benedetto
ISBN: 9781119512127 (hardback), 9781119512134 (ePDF), 9781119512158 (ePub)

This is Part 2 of the Milan office case study. Part 1 covered the building, rent roll, and market data. Now we build the DCF model and get to a number.

The property is a partially vacant office near central Milan. About 40% empty. Four tenants on different lease terms. ERV around €185/sqm. Market gross yield around 7%.

Choosing the time horizon

The ideal horizon is the shortest period after which cash flows stabilise.

Here: 6.5 years.

Why? Tenant B has the longest remaining lease at 5.5 years. Tenant C’s rent will likely reset to ERV at the break option. Vacant floors need 12 months to lease. Add one year for refurbishment and re-leasing after Tenant B’s departure. That gets you to roughly 6.5 years.

Cash flows are modelled in six-month periods. Quarterly would not add much precision.

Building the cash flows

Income

Rents are the main benefit. For leased units, use actual passing rent with 75% CPI indexation. For vacant units, use ERV starting after a 12-month leasing period.

Tenant C’s rent drops to ERV at the break option (visible in the model around semester 4).

The “Closer Look” on growth rates is worth reading. Linking everything to inflation is common but dangerous. After 2008, rents fell in many markets even with positive inflation. ERV does not always track inflation. Some valuers assume zero ERV growth early in the plan, then align with inflation later. Others tie ERV growth to GDP. The key rule: be consistent within the same valuation date across all properties in a portfolio.

Vacancy and credit loss

Three ways to handle this (and don’t double count):

1. Model specific known events (a tenant gave notice, a dispute is pending)
2. Apply a percentage vacancy rate (works for multi-tenant, not single-tenant)
3. Bake it into the discount rate’s rental risk premium

For this case:

• Leased units: zero vacancy during lease term (no break options assumed exercised)
• Vacant floors: leased within 12 months
• All current tenants: solid credit, no default assumed
• New tenants: credit risk captured in the discount rate, not as explicit loss

Operating expenses

Italian law puts property taxes, insurance, and extraordinary maintenance on the owner. Assumptions:

• Property taxes: actual amount, indexed to inflation
• Insurance: actual amount, indexed
• Stamp duty: 0.50% of rents
• Extraordinary maintenance: 0.50% of reconstruction cost (€1,100/sqm construction cost)
• Property and facility management: 2.00% of rents (market benchmark, not actual owner cost)

The book warns about using actual costs when the owner’s management company charges non-market fees. Always check if expenses reflect market rates.

Investments

• €300,000 CapEx in semester 1 for fire prevention compliance
• €50/sqm tenant improvements at each tenant turnover (indexed to inflation)
• 10% leasing fee on first-year headline rent for each new lease

Terminal value

Applied direct capitalisation to the income in the period after the last cash flow (time N+1).

Used Effective Gross Income (not NOI) because comparable sales only provide gross yields. Operating costs for comparables are unknown.

Going-in cap rate: 7.0% (from market analysis).

Going-out cap rate: 7.25% (+50 bps for building obsolescence over the holding period).

No HBU change assumed at expiry. The spread reflects aging, not a use change.

Brokerage fees on sale: 0.5% of terminal value.

Discount rate (WACC)

Built using the Build-Up Approach from Chapter 7.

Financial structure: 60% debt, 40% equity (market assumption for this asset type).

Cost of debt (Kd): 3.83%

• Risk-free: six-month average of 5-year EUR IRS = 0.33%
• Bank spread from survey = 3.50%

Cost of equity (Ke): 13.80%

• Risk-free: 5-year BTP average = 1.80%
• Risk premiums:
  • Property sector: 600 bps
  • Location: 150 bps
  • Intended use/typology: 150 bps
  • Physical/technical features: 100 bps
  • Rental/contractual risk: 200 bps

WACC = (3.83% × 60%) + (13.80% × 40%) = 7.82%

Rents and costs assumed received/paid mid-period. Sale proceeds assumed at period start.

The result

About 70% of the value comes from the terminal value. That is normal for DCF models with a cap-rate exit. It also means the going-out cap rate and stabilised income assumptions carry enormous weight.

Sanity check: direct capitalisation

The book runs the same property through direct capitalisation for comparison.

• Potential Gross Income: €185/sqm × 16,035 sqm = €2,966,475
• Cap rate (GICR): 7.50% (7.0% market + 0.50% vacancy risk premium)
• Less CapEx: €300,000
• Less TIs for vacant space: €317,625
• Result: approximately €38,940,000

The two methods agree within about €80,000. Close enough to feel comfortable.

But the book argues DCFA is still preferable here. Why? Because 40% vacancy and staggered lease expiries create a cash flow story that a single income figure and cap rate cannot explain. Direct capitalisation is also hypersensitive to cap rate choice. A few basis points change the value significantly.

Side boxes worth noting

Vacancy and credit loss (Closer Look 9.2): Applying a flat 5% vacancy to a single-tenant building makes no sense. It is either 0% or 100%. Yet some valuers do it anyway.

Operating expenses (Closer Look 9.3): Extraordinary maintenance is often spread as a flat percentage per period because timing real capex is hard. Limited impact on value, so the simplification is accepted.

Growth rates (Closer Look 9.1): Inflation for costs and contractual rents. Different growth for ERV based on local market dynamics. Do not mix them up.

My take

This case study is the book’s best proof that DCF is not just theory. The spreadsheet has 14 six-month periods, six rent lines, vacancy adjustments at tenant turnover, CapEx, TIs, leasing fees, and a full WACC build-up.

The number that stuck with me: tenant C’s rent reset. One line in the model drops income by roughly €14,000 per semester when the break option hits. That single judgment call moves the final value.

If you’re learning DCF valuation, work through this case with the Excel files on cpv-mb.com. The book gives you the logic. The spreadsheet gives you the mechanics.

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