The German way of valuing property: Investigating the difference between discounted cash flow and the German income approach

The German property market differs from most of its international counterparts in its comparatively low but remarkably stable performance over the past decades. One of the possible reasons for this anomaly could be the German appraisal method referred to as the German Income Approach (Ertragswertverfahren) which is often said to result in an even smoother pattern than the internationally applied Discounted Cash Flow technique. Due to an increasing number of German investors using DCF it was possible to assemble a dataset of almost 3,000 individual German office & retail properties from 2005 to 2010 with a sufficiently large proportion of DCF valuations to allow for a meaningful comparison within the same market. In order to establish whether and to what extent GIA valuations differ from DCF valuations two separate hedonic indices are derived. A novelty of the paper is the integration of valuation and transaction data. Market data is used to derive transaction prices for every property over the time period under investigation. This theoretical transaction price is used to approximate the average margin of error for each appraisal technique. The Heckman two-step procedure (Heckman, 1979) is employed in order to correct for possible sample selection bias. The objective of this paper is to offer more insight into the question which appraisal method more accurately predicts transaction prices on the German property market. A preliminary analysis indicates that there are significant differences between valuations following DCF and GIA.