Last updated on Mar 22, 2024
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What is the discount rate?
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How to calculate the discount rate?
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How to adjust the discount rate?
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Here’s what else to consider
The discount rate is a key factor in the valuation of commercial properties, as it reflects the expected return and risk of the investment. But how do you determine the most appropriate discount rate for a specific property? In this article, we will explain the concept of the discount rate, the main methods to calculate it, and some tips to adjust it for different scenarios.
Key takeaways from this article
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Build-up method:
Use the build-up method to calculate the discount rate by starting with a risk-free rate and adding premiums for equity risk, size, liquidity, and specific property risks. This approach customizes the rate to fit the unique investment profile.
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Adjust for scenarios:
Consider factors like holding period and growth rate when calculating your discount rate. A longer hold means more uncertainty, thus a higher rate; higher growth suggests lower risk, which can mean a lower rate.
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- Norman Quinn
1 What is the discount rate?
The discount rate is the interest rate that is used to convert future cash flows into present values. It represents the opportunity cost of investing in a property, or the minimum return that an investor would accept for the investment. The higher the discount rate, the lower the present value of the property, and vice versa. The discount rate depends on various factors, such as the market conditions, the property characteristics, the investor profile, and the alternative investments available.
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- Norman Quinn
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Finance tries to ideally link risk and return. The more risk the higher the return. Entities investing funds have expected return rates for the investment timeline. The task is matching, but the risks must be fully understood, or investors may be disappointed.
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The first thing, you need to remind yourself when calculating a "cap" rate is understanding that capital flows are what determines the (cap) rate! While supply and demand are inextricably linked to flows in capital markets, real estate markets are far less efficient and predictable than public markets (stocks/bonds) and require a more granular analysis. Interest rates matter only to the extent that they affect capital flows and in countries like the US that are currently seen as "safe havens", they form the basis for for spreads/premiums above a "risk" free return.
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It's a multi-factor question that you'll have to determine for yourself, depending on your objective. Calculating the most appropriate discount rate for a commercial property involves many factors and considerations. The discount rate, often referred to as the "required rate of return" or "yield", reflects the risk associated with an investment and is used to determine the present value of the property's future cash flows.
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The discount rate is the interest rate used to convert future cash flows into present values, crucial for assessing a commercial property's investment potential. It represents the minimum return investors would accept and is influenced by market conditions, property specifics, investor preferences, and alternative investments available. Adjusting the discount rate enables investors to accurately evaluate profitability and align their investment strategy with their objectives and risk tolerance.
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2 How to calculate the discount rate?
There are different methods to calculate the discount rate for a commercial property, but the most common ones are the capital asset pricing model (CAPM) and the build-up method. Both methods start with a risk-free rate, which is usually based on the yield of a long-term government bond, and then add various risk premiums to account for the additional risk of investing in a property.
The CAPM method uses the following formula: Discount rate = Risk-free rate + Beta x Market risk premium The beta is a measure of the property's sensitivity to the market movements, and the market risk premium is the difference between the expected return of the market portfolio and the risk-free rate. The CAPM method requires reliable data on the beta and the market risk premium, which can be difficult to obtain for commercial properties.
The build-up method uses the following formula: Discount rate = Risk-free rate + Equity risk premium + Size premium + Liquidity premium + Specific risk premium The equity risk premium is the difference between the expected return of the equity market and the risk-free rate, and it reflects the general risk of investing in stocks. The size premium is an additional return that investors demand for investing in small companies or properties, as they tend to be more volatile and less diversified. The liquidity premium is an extra return that investors require for investing in illiquid assets, such as properties that are difficult to sell quickly. The specific risk premium is a customized adjustment that reflects the unique characteristics and risks of the property, such as its location, quality, tenant mix, lease terms, and management.
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Risk premium: Commercial real estate entails specific risks, such as economic fluctuations, market conditions, vacancy of premises, etc. You need to estimate the risk premium required to offset these risks. This premium can vary depending on factors such as location, property type, market conditions and the specific risks associated with the property. It comes down to Marketing's famous P's: Product, Place, Price - the higher your P, the more risk you can afford, supply and demand.
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Calculating the discount rate for a commercial property involves utilizing methods like the capital asset pricing model (CAPM) or the build-up method. These approaches typically start with a risk-free rate, adjusted for various risk premiums associated with the property investment.
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3 How to adjust the discount rate?
The discount rate is not a fixed or static number, but rather a dynamic and flexible one that can change over time and across different scenarios. Therefore, it is essential to adjust the discount rate according to the specific circ*mstances and assumptions of the valuation. For instance, the holding period, growth rate, leverage, tax rate and market conditions can all affect the discount rate. The longer the holding period, the higher the uncertainty and risk of the future cash flows, thus increasing the discount rate. On the contrary, a higher growth rate implies a higher return potential and lower risk, causing a decrease in the discount rate. Additionally, leverage increases financial risk and cost of capital, while a higher tax rate reduces after-tax cash flows and return on equity, both resulting in an increase in the discount rate. Moreover, market conditions can influence the supply and demand of properties, availability and cost of capital, inflation and interest rates as well as investor expectations and preferences - all impacting the discount rate.
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Adjusting the discount rate is crucial for accurate property valuation. Factors like holding period, growth rate, leverage, tax rate, and market conditions influence the discount rate. Longer holding periods raise uncertainty, increasing the discount rate. Higher growth rates decrease risk, lowering the discount rate. Leverage increases financial risk, raising the discount rate, while higher tax rates reduce after-tax cash flows, also increasing the discount rate.
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Don't forget to make adjustments for:1. Asset Class - For example, hotels (nightly leases = more variability / management intensity = higher cap rate) vs. multifamily (annual leases = more stability / hands off = lower cap rate)2. Geography3. Tenant Credit Quality
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Evaluate the impact of vacancy: Start by assessing the impact of vacancy on the overall performance of the property. A high vacancy rate can lead to lower rental income and higher management costs, affecting the property's profitability.Analyze vacancy risksIncorporate risk into the discount rateUse valuation models that take vacancy into accountPerform sensitivity analysisPeriodic reviewBy adjusting the discount rate to account for vacancy risk, you can obtain a more accurate estimate of commercial property value and make more informed investment decisions.
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4 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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- Demetri Stakias Founder @ Real Estate Relief | Investors in commercial properties. We buy in FL and PA
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Be mindful of where you are buying and the timeline so that you are ready and plan for the cost of capital in tying it down for a longer time period
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