The required rate of return is a critical property investment and pricing metric, which determines to a great extent the price that a property investor is willing to pay for acquiring a property.
Simply put, given the expected income or price appreciation of a particular property, the investor will pay as maximum price the price that achieves the minimum rate of return that he/she requires in order to commit his funds for the acquisition of the property. The required rate of return is actually the discount rate that is used in the discounted cash flow model for the estimation of the present value of the expected net cash flows from a property investment.
According to the property investment literature, a typical way for estimating the required return is by summing three components:
• Real rate of return – this is usually calculated as the difference between the long term rate of return on government securities and inflation, and ranges between 2 and 3% according to some studies
• Inflation premium – the expected general price inflation over the holding period
• Risk premium – this is determined by the risk characteristics of the property as assessed by the investor; such risk characteristics vary depending mainly on the characteristics of the particular property, its location, the general economic and financial environment and the characteristics of existing leases and tenants in the case of income producing property. The higher the risk associated with the future cash flows of the property including is future resale price, the higher the risk premium and the higher the required return, all else being equal