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Estimating Discount Rates
In principle, the discount rate used to evaluate a real estate investment should reflect the
risk-adjusted cost of capital of the investor. While this is a straightforward theoretical
concept, it is often difficult to come up with a concrete measure of this cost.
If you recall from finance, for stock and bond investments we can use public market
information to estimate the rate of return investors are earning in the market. For capital
budgeting decisions, it was argued that the firm should use its weighted average cost of
capital as a discount rate.
Real estate investments have some commonalities with both publicly traded securities
and less liquid capital budgeting projects. As such, we will use an amalgam of the
techniques used in corporate finance to get a ballpark estimate of the required discount
rate.
Always beware, however, of the myth of precision. Because we are only getting a rough
estimate of the correct discount rate, don’t let yourself be fooled into thinking “Well, my
NPV is positive $13.53, thus I should accept the project.” If a small change in the
discount rate you use makes a big different in your investment decision, be careful.
Risk Premium Method
Recall that the overall discount rate for the property, rp, can be broken down as
rp = rrf + rrp,
where rrf is the risk free rate (as estimated by the one-year Treasury security) and rrp is
the risk premium investors will demand for holding the risky real estate asset.
Historical statistics on annual returns suggest that fully-leased, free-and-clear (no debt),
institutional investment properties have commanded a 3.50 percent risk premium over
one-year T-Bills. Thus, one way to estimate the discount rate for the property is to look
at current one-year T-Bill rates and add 3.50 percent.
One caveat is that the risk premium is not necessarily stable over time. For example,
recently the one-year T-Bill was trading at about 1.50 percent. If the risk premium for
real estate was still at 3.50 percent, this suggests a required return of about 5.00 percent
for investment grade real estate. On the other hand, if the risk premium had increased
due to the current economic environment, it would not be unreasonable to expect a 6.00
or 7.00 percent required return on real estate.
Cap Rate Method
An alternative method of estimating discount rates is to use market cap rates. If we
assume that a property’s net operating income (NOI) will increase at a constant rate for
the indefinite future, then the return on the property will be
rp = cap rate + annual NOI growth.
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