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8/13/2014 What You Should Know About the Discount Rate

http://www.propertymetrics.com/blog/2013/09/27/npv-discount-rate/ 1/11
BuildaProforma
Now
LEAVEACOMMENT
WhatYou
ShouldKnow
Aboutthe
DiscountRate
SEPTEMBER27,2013BYROBERTSCHMIDT
Thediscountrateisoneofthemostfrequently
confusedcomponentsofdiscountedcashflow
analysis.Whatexactlyisthediscountrateandhow
doesitwork?WhatdiscountrateshouldIuseinmy
analysis?Theseareallimportantquestionstoask,
andthisarticlewillexplaintheanswersindetail.Read
onforadeepdiveintotheconceptofthediscountrate
asitrelatestovaluationanddiscountedcashflow
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8/13/2014 What You Should Know About the Discount Rate
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analysis.
DiscountRateDefinition
Whatisthediscountrate?Thediscountrateistherate
ofreturnusedinadiscountedcashflowanalysisto
determinethepresentvalueoffuturecashflows.
Inadiscountedcashflowanalysis,thesumofallfuture
cashflows(C)oversomeholdingperiod(N),is
discountedbacktothepresentusingarateofreturn
(r).Thisrateofreturn(r)intheaboveformulaisthe
discountrate.
DiscountRateIntuition
Mostpeopleimmediatelyunderstandtheconceptof
compoundgrowth.Ifyouinvest$100,000todayand
earn10%annually,thenyourinitialinvestmentwill
growtoabout$161,000in5years.Thishappens
becauseyourinitialinvestmentisputtoworkand
earnsadividendand/orappreciatesinvalueover
time.
Whensolvingforthefuturevalueofmoneysetaside
today,wecompoundourinvestmentataparticular
rateofinterest.Whensolvingforthepresentvalueof
futurecashflows,theproblemisoneofdiscounting,
ratherthangrowing,andtherequiredexpectedreturn
actsasthediscountrate.Inotherwords,discounting
ismerelytheinverseofgrowing.
inCommercialRealEstate
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ReservesinCommercial
RealEstate
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AboutTheTimeValueof
Money
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Work?
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OccupancyRatioWorks
POPULAR POSTS
WhenWillCommercialReal
EstateFullyRecover?
IntuitionBehindIRRandNPV
U.S.JobGrowthbyState
WhatYouShouldKnow
AbouttheCapRate
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8/13/2014 What You Should Know About the Discount Rate
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DiscountRateSensitivity
Whenitcomestodiscountedcashflowanalysis,your
choiceofdiscountratecandramaticallychangeyour
valuation.Considerthefollowingchartshowingthe
sensitivityofnetpresentvaluetochangesinthe
discountrate:
Asshownintheanalysisabove,thenetpresentvalue
forthegivencashflowsatadiscountrateof10%is
equalto$0.Thismeansthatwithaninitialinvestment
ofexactly$1,000,000,thisseriesofcashflowswill
yieldexactly10%.Astherequireddiscountrates
moveshigherthan10%,theinvestmentbecomesless
valuable.
Thishappensbecausethehigherthediscountrate,
thelowertheinitialinvestmentneedstobeinorderto
achievethetargetyield.Asyoucanseeinthechart
above,theselectionofthediscountratecanhavea
bigimpactonthediscountedcashflowvaluation.For
morebackgroundonthenetpresentvalue(NPV),
checkouttheIntuitionBehindIRRandNPVandNPV
vsIRR.
SelectingaDiscountRateFor
anIndividualInvestor
Sincethediscountratematterssomuch,howdoyou
helpfulinmyunderstanding
ofcommercialrealestate.
Thepresentationand
informationprovidedis
astuteandalwaystothe
pointwithgreatclarity.
PropertyMetricsistruly
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OsceolaPartners,LLC
"Iamveryimpressedwith
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investmentclasslastweekif
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incomepropertyusing
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thanmyprofessor.THANKS
PropertyMetrics!"
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8/13/2014 What You Should Know About the Discount Rate
http://www.propertymetrics.com/blog/2013/09/27/npv-discount-rate/ 4/11
goaboutselectingtheappropriatediscountrateforan
individualinvestor?Noncorporateorindividual
investorsnormallyconsidertheiropportunitycostof
capitalwhendeterminingtheappropriatediscount
rate.
Whatistheopportunitycostofcapital?Simplyput,its
therateofreturntheinvestorcouldearninthe
marketplaceonaninvestmentofcomparablesizeand
risk.Itstheopportunitytheinvestorwouldbegivingup
ifhe/sheinvestedinthepropertyorinvestmentin
question,thusthetermopportunitycost.
Forexample,ifyouhave$1,000,000toinvest,what
areallofyouravailableinvestmentalternativeswith
similarriskprofiles?Whatevertheyieldisonallof
thesealternativeopportunitiesistheappropriate
discountratetouse.Anotherwaytothinkaboutthisis
thatforanindividualinvestorthediscountrateis
simplytheindividualinvestorsrequiredrateofreturn.
SelectingaDiscountRateFora
CorporateInvestor
Selectingtheappropriatediscountrateforacorporate
investorisabitmoredifficult.Corporationsoftenuse
theWeightedAverageCostofCapital(WACC)when
selectingadiscountrateforfinancialdecisions.
Broadlyspeaking,acompanysassetsarefinanced
byeitherdebtorequity.Acorporationcanalsouse
retainedearnings,whicharetheaftertaxearningsnot
distributedtoshareholdersintheformofadividend.
TheWAACissimplytheweightedaverageofeachof
thesesourcesoffinancing.Thisisalsocommonly
8/13/2014 What You Should Know About the Discount Rate
http://www.propertymetrics.com/blog/2013/09/27/npv-discount-rate/ 5/11
calledthehurdlerate,becauseforanenterpriseto
beprofitableithastoearnareturngreaterthanthe
costofcapital.Inotherwords,itmustcrossoverthe
hurdleinordertobeprofitable.
Thedebtportionofthecapitalstructureistypicallyin
theformofshorttermunsecurednotesprovidedby
commercialbanks,andlongtermdebtisusually
providedbybondinvestors.Theequityportionof
thecapitalstructureisnormallyintheformofpreferred
stockandcommonstock.Theinterestpaidonshort
andlongtermdebtisdeductiblefortax
purposes,whereasthedividendspaidtoshareholders
isnot.Anyaftertaxearningacorporationgenerates
thatisnotpaidouttoinvestorsiskeptasretained
earnings.
Considerthefollowingexample:
Tofindthebeforetaxweightofeachsourceofcapital,
youcansimplymultiplythepercentoftotalfigurefor
eachsourcebythebeforetaxcostofeachsource.For
example,shorttermdebtcomprises10%ofthetotal
capitalandhasacostof3.75%.Multiplyingthesetwo
figurestogetherresultsinabeforetaxweightof
0.38%.
Completingthisforeachsourceofcapitalresultsina
totalweightedaveragecostofcapitalof6.80%.This
istheappropriatediscountratetouseforthis
corporateinvestor.Anyinvestmentthatthecompany
8/13/2014 What You Should Know About the Discount Rate
http://www.propertymetrics.com/blog/2013/09/27/npv-discount-rate/ 6/11
makesmustatleastachievea6.80%returninorderto
satisfydebtandequityinvestors.Anyreturngreater
than6.80%willcreateadditionalvalueforthe
shareholders.
DiscountRatesandHistorical
AssetClassReturns
Anotherwaytothinkaboutthediscountrateistolook
athistoricalassetreturnsfortheinvestmentin
question.Considerthefollowingchartshowing
historicalassetreturnsbetween19702010:
Theabovechartshowshistoricalassetclassreturns
forTreasuryBills,longtermU.S.
governmentbonds,institutionalqualitycommercial
realestateasmeasuredbyNCREIF,andstocksas
measuredbytheS&P500.Additionally,thechart
breaksoutthevolatilityandcalculatestherisk
premiumofeachassetclassoverandaboveTreasury
Bills,whicharetraditionallyconsideredriskfreein
finance.
Asshownabove,theriskpremiumoninstitutional
qualitycommercialpropertiesrepresentedbythe
NCREIFindexaveraged4.55percent(or455basis
points).Theriskpremiumonlongtermbondswas
366basispoints,whiletheriskpremiumonstocks
8/13/2014 What You Should Know About the Discount Rate
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wasthehighest,at596basispoints.
Infinance,thetotalrateofreturnconsistsoftwoparts:
theriskfreerateplussomeriskpremium(r+RP).For
shortterminvestments,thetraditionalchoiceforthe
riskfreerateisthecurrentTBill.However,because
commercialrealestateisalongerterminvestment
withanaverageholdingperiodof10years,the
appropriateriskfreerateistheaverageTBillrate
expectedovertheinvestmenthorizon.
Fora10yearholdingperiod,the10YearTBond
wouldbeanappropriatechoice.Asanaside,
sometimeseventhe10YearTBondyieldisadjusted
downwardtoaccountfortheyieldcurveeffect,which
istheadditionalriskpremiumalreadybuiltintotheT
BondoverandabovetheshortertermTBillyields.
Ifthesehistoricalriskpremiumsrepresentcurrent
expectations,thenwecanusetheriskfreerate
calculated,andaddinthehistoricalriskpremiumto
determinethetotalexpectedreturn.Forexample,ifthe
riskfreeratewasdeterminedtobe3%,thenaddingin
theabove4.55%riskpremiumwouldsuggestatotal
returnexpectationof7.55%forinstitutionalquality
commercialrealestate.
DiscountRatesandExpected
Returns
Becausewhathappenedinthepastisnotaguarantee
ofwhatwillhappeninthefuture,itsoftenusefultolook
atexpectedreturnsgoingforward.Inadditiontothe
historicalreturnsdiscussedabove,anotherapproach
toestimatingthecurrentexpectedtotalreturnisto
8/13/2014 What You Should Know About the Discount Rate
http://www.propertymetrics.com/blog/2013/09/27/npv-discount-rate/ 8/11
simplyaskinvestorswhattheyexpect.
Ofcoursethisisalwayseasiersaidthandone.Most
largercommercialbrokeragefirmscollectdataon
thesereturnexpectationsonaregularbasis,asdo
someappraisersandlenders.Additionally,thereare
severalcommercialrealestateresearchfirmsthat
surveyinvestorpreferencesonaregularbasis.Oneof
themostpopularsurveysistheKorpaczsurvey.While
expensive,thisreportisregularlyusedbyinstitutional
investors.SomeofthelargerbrokerageslikeCBRE
alsoissuesimilardiscountratesurveysforfree.
RelationshipBetweentheCap
RateandtheDiscountRate
Becausecapratedataiseasiertoobtainthan
investorIRRexpectations,itsalsoworthmentioning
therelationshipbetweenthecaprateandthediscount
rate.YoumayrecalltheGordonModelfromourarticle
onthecaprate:
ThisformulasolvesforValue,givencashflow(CF),
thediscountrate(k),andaconstantgrowthrate(g).
FromthedefinitionofthecaprateweknowthatValue
=NOI/Cap.Thismeansthatthecapratecanbe
brokendownintotwocomponents,kg.Thatis,the
caprateissimplythediscountrateminusthegrowth
rate.Usingsomebasicalgebrawecanofcoursere
arrangethishandyequationandsolveforthediscount
8/13/2014 What You Should Know About the Discount Rate
http://www.propertymetrics.com/blog/2013/09/27/npv-discount-rate/ 9/11
rate.Thistellsusthatthediscountrateisequaltothe
caprateplusthegrowthrate.
Mostmediumandlargebrokeragefirmsissue
quarterlymarketreportsthatincludecaprateson
recenttransactions.Reportingcapratedataismuch
morecommonthanreportingIRRexpectations.This
meansyoucanestimatetheappropriatediscountrate
basedoncurrentcapratesinyourmarket.Simply
taketherelevantcaprateandaddinareasonable
growthestimateandyoullhaveanapproximate
discountratetouseinyourdiscountedcashflow
analysis.
Onelimitationtothisapproachisthatcapratedatais
basedonproformanetoperatingincome,notcash
flowbeforetax.Toaccountforthisdifferenceits
sometimescommontosimplyadjustthecaprate
downwardby100200basispoints.
TheDiscountRateand
DiscountedCashFlowAnalysis
Thediscountrateisacrucialcomponentofa
discountedcashflowvaluation.Thediscountratecan
haveabigimpactonyourvaluationandthereare
manywaystothinkabouttheselectionofdiscount
rates.Hopefullythisarticlehasclarifiedandimproved
yourthinkingaboutthediscountrate.Ifyouneedhelp
buildingacommercialrealestateproformaand
completingadiscountedcashflowanalysis,youmight
considergivingourcommercialreal
estateanalysissoftwareaspin.

8/13/2014 What You Should Know About the Discount Rate


http://www.propertymetrics.com/blog/2013/09/27/npv-discount-rate/ 10/11

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