## **Learning Outcomes**

This article explains real estate and infrastructure valuation techniques for the CFA Level 2 exam, including:

- understanding how discounted cash flow (DCF) models are structured, how to project net operating income (NOI), and how to calculate present values and terminal values;
- applying the direct capitalization approach to stabilized income-producing properties, deriving and interpreting market-based capitalization rates, and spotting when this shortcut is inappropriate;
- using market comparables to estimate value, selecting relevant transactions, computing price multiples, and making disciplined quantitative and qualitative adjustments;
- comparing DCF, direct capitalization, and comparables across different asset types and market conditions, and judging which method is most defensible in exam-style scenarios;
- identifying key input assumptions—discount rates, growth expectations, cap rates, and benchmark metrics—and assessing how sensitive valuations are to changes in these parameters;
- recognizing common modelling, data, and interpretation errors that appear in CFA Level 2 questions, and understanding how to correct them systematically;
- integrating all three approaches to cross-check valuations, reconcile differing indications of value, and clearly justify conclusions within the constraints of exam time limits.

## **CFA Level 2 Syllabus**

For the CFA Level 2 exam, you are expected to understand the main valuation methods for real estate and infrastructure investments, with a focus on the following syllabus points:

- Explaining and applying discounted cash flow (DCF) valuation to income-producing real assets
- Calculating values using direct capitalization and interpreting cap rates
- Using market comparables (comparative method) for asset appraisal and recognizing the selection of appropriate benchmarks
- Distinguishing strengths and weaknesses of each approach
- Identifying inputs, assumptions, and procedures needed for application and comparison

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which fundamental input do both the DCF and direct capitalization methods rely upon to estimate real estate value?
2. A property generates annual net operating income (NOI) of \$500,000. If appropriate market cap rates are 5%, what is the property’s direct capitalization value?
3. How does the market comparables approach differ conceptually from a DCF valuation?
4. Name one scenario in which the direct capitalization method is inappropriate.

## **Introduction**

The valuation of real estate and infrastructure assets is central to CFA Level 2 exams and widely used by investment analysts, lenders, and fund managers. You need to value these assets reliably to support investment decisions and pricing. The three most common methods are discounted cash flow (DCF) analysis, direct capitalization, and use of comparables. Each approach uses different data and assumptions but shares the objective of estimating fair market value.

> **Key Term: Net Operating Income (NOI)**
> Income from a property after deducting operating expenses but before interest and taxes. NOI is the fundamental cash flow measure in income-based real estate valuation.

## DISCOUNTED CASH FLOW (DCF) VALUATION

DCF analysis values a real estate or infrastructure asset by estimating its future cash flows and discounting them to present value using an appropriate discount rate.

The process involves projecting explicit cash flows over a forecast period (usually 5–10 years), then assigning a terminal value reflecting the asset's value at the end of the forecast. Both are discounted to present value. DCF is especially suited for assets with clearly identifiable cash flows and where future performance may change over time due to leasing, development, or operational factors.

> **Key Term: Discount Rate**
> The required rate of return reflecting the time value of money and risk of the cash flows from a property or infrastructure asset.
>
> **Key Term: Terminal Value**
> The value assigned to an asset at the end of the explicit forecast period in a DCF model, reflecting its resale or continued income beyond the forecast horizon.

### **Worked Example 1.1**

**A logistics warehouse has the following projected annual NOI:**  
Years 1-3: \$1.2m/year; Years 4-5: \$1.4m/year.  
**If the required discount rate is 7% and the terminal cap rate at Year 5 is 6%, calculate the DCF value.**

> **Answer:**
>
> - Discount the each year's NOI at 7% back to present.
> - Terminal value in Year 5 = \$1.4m / 0.06 = \$23.33m
> - Present value of explicit NOI years + present value of terminal value = sum of [NOI_t / (1.07)^t] + [\$23.33m/(1.07)^5].
> - The sum is the property’s DCF value.

### **Exam Warning**

> The most common DCF error is inconsistency between the discount rate and cash flows. The discount rate must reflect the risk profile of the projected cash flows. Do not use WACC if the cash flows are levered net income.

## DIRECT CAPITALIZATION APPROACH

The direct capitalization approach provides a simple one-step valuation used primarily for stabilized, income-producing assets. It divides the property’s expected NOI by a market-derived capitalization rate ("cap rate"). This method assumes future income and expenses are stable.

> **Key Term: Capitalization Rate (Cap Rate)**
> The ratio of a property's net operating income to its market value. Used to convert NOI into value under the direct capitalization approach.

### **Worked Example 1.2**

**A student housing building generates \$700,000 in annual NOI. Comparable sales indicate cap rates for similar properties are 5.5%. What is its direct capitalization value?**

> **Answer:**
> Direct capitalization value = NOI / Cap Rate = \$700,000 / 0.055 = \$12,727,273

### **Revision Tip**

> Direct capitalization is not appropriate for assets with volatile, unpredictable, or growing cash flows. Use DCF instead in such cases.

## MARKET COMPARABLES APPROACH

The comparables method (also called the sales comparison or market approach) values a property by reference to observed sales prices for similar assets. Adjustments are made for differences in property type, location, physical condition, and lease terms to arrive at an estimated relative value.

> **Key Term: Comparable (Comp)**
> A recently sold or listed asset with characteristics similar to the subject property, used as a pricing benchmark in the comparables approach.

### **Worked Example 1.3**

**A hospital is for sale. Recent sales of similar hospitals averaged \$3 million per bed. If the subject has 120 beds, what is its market value estimate before physical adjustments?**

> **Answer:**
> Market value estimate = \$3m × 120 = \$360m, to be further refined by adjusting for age, location, and quality.

### **Exam Warning​**

> Ensure adjustments to comparables reflect genuine economic differences, not market noise. Failing to adjust for unexpired lease incentives or unique amenities will bias your result.

## STRENGTHS AND LIMITATIONS OF EACH METHOD

- **DCF**: Highly flexible, captures changes in income streams and timing; requires extensive forecasts and is sensitive to terminal assumptions.
- **Direct capitalization**: Quick and objective if market data is available; not suitable for volatile or non-stabilized cash flows.
- **Comparables**: Reflects prevailing market pricing; limited by availability and reliability of similar recent transactions and accuracy of adjustments.

## **Summary**

Valuing real estate and infrastructure investments relies on understanding and correctly applying three main methods: DCF analysis (best for assets with variable income), direct capitalization (for stable properties), and comparables (when many recent sales exist). Each has distinct data requirements and limitations, so you must choose and justify the appropriate method for each scenario on the CFA Level 2 exam.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- The three main valuation methods: discounted cash flow (DCF), direct capitalization, and market comparables
- Calculation and interpretation of NOI, discount rate, and terminal value in DCF analysis
- Application of direct capitalization using market-derived cap rates for stabilized assets
- Use of comparable sales and adjustments in market-based valuation
- Strengths and practical limitations of each method and when each is appropriate
- Common exam errors, such as mismatched discount rates and cash flows or missing necessary adjustments

## **Key Terms and Concepts**

- Net Operating Income (NOI)
- Discount Rate
- Terminal Value
- Capitalization Rate (Cap Rate)
- Comparable (Comp)

Real estate and infrastructure - Valuation dcf direct capitalization and comparables