A few weeks ago, I was in a meeting with about 15 smart real estate and finance people, many of whom have Ivy League MBA’s. We spent about 20 minutes discussing and debating the use of Discount Rates in analyzing real estate investments. Since there was some confusion among the group about how to select an appropriate discount rate, I’ve decided to write a post about it. Here goes.
In commercial real estate, the discount rate is used in discounted cash flow analysis to compute a net present value. The discount rate is defined below:
Discount Rate – The discount rate is used in discounted cash flow analysis to compute the present value of future cash flows. The discount rate reflects the opportunity costs, inflation, and risks accompanying the passage of time.
There is not a one-size-fits-all approach to determining the appropriate discount rate. That is why our meeting went from a discussion to a lively debate. However, a general rule of thumb for selecting an appropriate discount rate is the following:
Small investors: Discount Rate = the investors’ required rate of return
Institutional investors: Discount Rate = Weighted Average Cost of Capital (WACC)
*WACC is defined as the weighted average of all capital sources used to finance an investment (i.e. debt & equity sources).
Using this approach, investors are able to ensure that their initial investment in the asset achieves their return objectives. Now that we have definitions and basics out of the way, lets dive into how discount rates are determined in practice and in theory.
Practically speaking, you can think of the discount rate as the expected rate of return, or IRR (without leverage). It can be thought of as the opportunity cost of making the investment. The opportunity cost, would be the cost related to the next best investment. In other words, the discount rate should equal the level of return that similar stabilized investments are currently yielding.
If we know that the cash-on-cash return for the next best investment (opportunity cost) is 8%, then we should use a discount rate of 8%.
Discount Rates are determined by our Level of Confidence
A discount rate is a representation of your level of confidence that future income streams will equal what you are projecting today. In other words, it is a measure of risk. A higher discount rate relative to a lower discount rate generally means that there is more risk associated with the investment opportunity. Therefore, we should discount future cashflows by a greater percentage because they are less likely to be realized. Conversely, if the investment is less risky, then theoretically, the discount rate should be lower on the discount rate spectrum. Therefore, the discount rate used when analyzing a stabilized class A apartment complex will be lower than the discount rate used when analyzing a ground-up shopping center development in a tertiary market.
The higher the Discount Rate, the greater the perceived risk
The lower the Discount Rate, the smaller the perceived risk
Keep in mind that the level of risk is a function of both the asset-level risk as well as the business plan risk. Asset risk is the product type, the market, the location etc. The business plan risk refers to the strategy behind the project. A ground-up development will have more business plan risk than a passive investment in a stabilized project.
Another way of thinking about a discount rate is through the Build-Up Method. This is a more academic approach than that of the opportunity cost approach. It is essentially a rate built by taking the risk free rate (US Treasury) and adding to it margins for the unique set of operating, market, and credit risks as well as a liquidity risk premium.
Discount rate = Risk Free Rate + Real Estate Risk Premium
A Few Examples . . .
If you are acquiring an existing stabilized asset with credit tenants then you could use a discount rate of around 7%. If you are analyzing a speculative development, you discount rate should be in the high teens. In general, discount rates in real estate fall between 6-12%.
Selecting the appropriate discount rate is an inexact science. As such, I can’t tell you exactly what discount rate to use. If you use the general guidelines and approaches outlined in this article, you have everything you need to make an appropriate selection.