The discount rate is the rate used to discount the stream of cash flows of a commercial property investment in order to estimate its present value.
It actually represents the required rate of return by a particular investor in order to commit capital to a property investment over a given period. For this reason, each individual investor, in considering and evaluating an investment, may use a different rate depending on his/her circumstances, return requirements and risk aversion. The choice of a discount rate is critical because minor changes can result in significant changes in an investment’s net present value
Choosing A Discount Rate
As indicated earlier, property investors choose the appropriate rate for discounting property cash flows, based on their required rate of return, which is strongly influenced by two sets of factors: a) achievable returns in alternative investment vehicles and b) risk factors.
The investor’s required or acceptable rate of return for a property investment depends on achievable returns in alternative investment vehicles, because property competes for funds with other asset classes in the capital market. Thus, if returns in alternative investment vehicles, such as stocks and bonds, rise, investors will require a higher rate of return, and thereby use a higher discount rate, in order to invest in property. Thus, the relationship between returns in alternative investment vehicles and discount rates for property is positive.
Risk factors represent the other major group of influences that affects required returns and discount rates for property. In general there is a positive relationship between the two variables, as investors tend to use a higher discount rate for properties that involve higher risk. The factors that determine the risk associated with property investments include:
1. Real estate market conditions
2. Economic conditions
3. Property Location
4. Property condition
Real Estate Market Conditions
The state of the local property market within wich a property is located is a very important determinant of the risk associated with its ownership. Research on capitalization rates by Sivitanidou and Sivitanides (1999) have shown that property investors behave myopically. In other words, they tend to form expectations for the future based on current market conditions. Thus, if local market conditions are good, that is, if the vacancy rate is low, demand is growing faster than supply, and rents are rising, then investors will perceive that the risk of property ownership is lower and the required rate of return, and, hence the discount rate, will be lower, all else being equal.
Local Economic Conditions and Prospects
The condition of the local economy plays also an important role in terms of a property’s risk rating and the investor’s required rate of return. Usually the local economy and property market move together to some extent because the latter is an important part of the former. However, due the increasing globalization of the economy, local economies are to a great extent influenced by national, regional, and global changes in economies and financial markets. Since demand for property depends on a growing economy, a slowing or stagnant economy will create more uncertainties regarding the expected cash flow stream that a property may deliver to its owner. For example, demand for office space depends on employment in office-using sectors. Thus, declining employment in office-using sectors will result in declining demand for office space, increasing vacancies and falling rents. Within this context, all else being equal, a healthy and growing local economy, will motivate property investors to consider a property less risky, and, thereby, use a lower discount rate when evaluating it. The contrary will be true in the case of a weak or declining economy.
Property location is another important determinant of the riskiness involved with property ownership and hence the required rate of return. All else being equal, properties located in poor locations should be considered more risky, thereby motivating investors to discount property cash flows using a higher rate. On the contrary, properties located at strong/prime locations should be considered less risky, dictating the use of a lower discount rate. The strength or weakness of a location depends on the property type considered, the specific land use patterns of the area, and urban/suburban growth dynamics and prospects. For example, for offices, locations on major transportation arteries, in established office space concentrations and corridors with high traffic exposure and proximity to ample business services, restaurants and shopping, are stronger than locations on secondary transportation arteries, non-established office locations, low traffic exposure and visibility and limited support services and facilities.
In the case of retail, proximity to and excellent access from large population concentrations with sufficient purchasing power, on high traffic corridors with high visibility and exposure, and excellent access from private and public transportation compose the elements of a strong location that would motivate investors to discount cash flows with a lower rate. Also the location of competitors with respect to the retail location examined is important. If a strong competitor is located or plans to open a shopping center within a retail property’s primary trade area, the investor will be strongly inclined to require a higher rate of return and discount associated cash flows with a higher rate because of increased risk.
A deteriorated property of medium conditions that has not been well maintained entails a greater risk of higher operating expenses and capital improvement costs, compared to a brand new property with modern electromechanical equipment and installations. For this reason an investor maybe inclined to require higher returns when investing in a property that is not in a very good shape.