Computing the Discount Rate
By: Christian O’Neal

The discount rate is the most fundamental concept in the commercial real estate investment industry to master, and it is widely regarded as a pillar in finance and investments in general. Investors use discounted cashflow analysis to solve for their maximum purchase prices when analyzing prospective investments. In doing so, investors can underwrite deals to their minimum required rates of return so they can meet equity return obligations to their capital partners. But what exactly is the discount rate and how does it work?

Let us examine what the discount rate is, how it works, why it is so relevant, and why it is especially hard to compute in the environment we find ourselves in today.

To understand its relevance, it is crucial to understand the ‘time value of money’ concept. The time value of money simply refers to the value of money today versus its value out into the future. Since our dollar is “fiat,” or no longer tied to gold, its value decreases throughout time because of inflation. A dollar today is worth more than a dollar tomorrow because you can buy more with it today, and its purchasing power is greater today than it will be tomorrow. As our currency is debased through money printing, the amount of total dollars in circulation (demand) rises faster than the amount of goods there are (supply) for the dollars to chase after. Therefore, we get rises in prices such as energy, food, housing, and commodities. Since 1960, the total money supply has expanded exponentially, as shown in the chart below:

Now that we understand the implications of inflation on our purchasing power, we can rightfully assume that investors would expect a higher return in the future on each dollar invested, relative to that return today. The discount rate factors this in as all future cashflows are not treated equally. The further out into the future cashflows are, the less they are worth.

In addition to inflation, the other item we must account for in computing our return requirements (discount rate) is something called opportunity cost. Opportunity cost refers to the missed returns or opportunity that one accepts by choosing an alternative. To further illustrate, imagine you have $10,000. By putting that $10,000 into a money market fund or savings account, you lose the opportunity to earn a higher rate of return elsewhere, such as in the private real estate market, REITS, or the stock market. Investors account for this and inflation in producing their annual return requirements.

The discount rate is simply the unlevered required annual return hurdle investors expect to receive from an investment, but it factors in the time value of money concept discussed above. Investors demand an annual return above ‘risk free rates,’ often pegged to US treasury rates since these bonds are as close as one can get to a “risk free” guaranteed return vehicle as possible. They are backed by the faith and credit of the US government through the world’s reserve currency, the US dollar. By applying a risk premium over and above these rates, investors can capture the perceived risk/reward opportunity through additional required return. This additional premium, or spread, corresponds to the amount of risk an investment strategy or type of investment has to offer. Core, stabilized properties with investment grade anchor tenants, or fully occupied Class A multifamily properties, for example, will demand the lowest risk premium over the risk-free rate. Vacant, older properties are inherently riskier and therefore require higher rates of projected return, made possible via lower purchase prices. Investors are willing to accept lower returns via a lower risk premium spread, in exchange for lower risk.

If we put it all together, we now know that the unlevered discount rate is made up of A) a risk-free rate & B) a risk premium rate. Cashflows in the future will be discounted by this annual discount rate hurdle. By using debt to capitalize a project, returns on equity should be larger than the unlevered discount rate because of the additional leverage on each dollar. If levered returns are not higher because of debt, then that implies the deal is negatively levered and the borrower would be better off using all equity to capitalize a project to generate higher returns.

In today’s market, it can be difficult to calculate the discount rate for a given project because of the volatility in risk free or treasury rates, as well as overall market uncertainty. When times are uncertain, investors tend to demand a higher spread as well to cushion themselves against potential future erosion in value.

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