DCF Analysis. How to get discount rate????

Question

Hey guys,

I have a question regarding DCF analysis. I have previous experience in finance but I am not sure what to do with discount rates on real estate investments. In finance, you can calculate the cost of equity using CAPM and cost of debt by looking at bond yields because there is such a highly analyzed public market.

What can we assume about real estate investment discount rates?

Bryan Hancock · Answer

Great question.  Let me know if you ever figure out the answer ;-)

You can probably use something simple like your loan constant and your required return on your equity.  Loan constants are commonly around 6-10% based on YOUR borrowing capacity and the type of investment you're looking at.  Equity requirements vary considerably, but 20% is common for real estate investors.

Ray Alcorn has a good article on this.  Try looking here:

Calculating a Derivative Capitalization Rate

Bill Gulley · Answer

Good work Bryan, kados on finding the blog!

It is the easiest way to identify the contributions using a motgaged and equity constant however, one thing to add;

The author used the mortgage interest rate, that is the note rate, you'll be better off using the APR which includes your loan expenses and points, especially when using money from a HML charging 5,7 or more in points! Doing so will better reflect your cost of money over the term.

This is pretty much why I don't get excited over landlords or investors speaking about cap rates and cash on cash returns, to be accurate, you need to look at the blended or weighted contributions to the deal.

Personally, I go a step further myself looking at the old mager's internal rate of return considering what managerial contributions will be needed as well. Some deals are time consuming after the purchase, looking at it strickly from a financial aspect and omitting the value of your continued efforts (as you could be doing something else) skews the big picture, the easiest way is to addvalue to your management contributions and include them as expenses with the NOI. Note too that such values are without tax benefits if you get to an after tax assumption.

Thanks for the link!

Bill Gulley · Answer

When you apply, or attempt to apply financial ratio analysis in RE using ratios derived for securities you're making an assumption that is not true, real estate is unique, no two parcels are the same. Securities are liquid assets, real estate is not.

This matter does have industry standards under FSAB accounting requirements in the valuation of long term leases that may be securitized and with commercial appraisal techniques. The matter is over simplified in residential and small investment property valuations for appraisals done in purchase transactions. However, an appraiser may be tasked to provide a private valuation for an entity where there is collaboration with that company's accounting and financial circles. As an example, I was asked to provide an appraisal on a property used by a large propane gas company, an unusual property with significant unique improvements (tanks and the craddles they sit in), there are no comparable sales.

If I knew a REIT was basing valuations on the 50% rule, I'd avoid that REIT, the larger sample is not valid in my mind, taking a census which includes housing costs rather than more reliable homogenious units to a comparable portfolio, but that's me. The 50% rule, while usually close, isn't close enough for me as actual computations on a particular property, granted, you need experience in that market and a history of management.

I'd say this matter of  DCF is beyond the scope of most investors on BP, I might go as far as to say that some attempt to solve or quantify thier investment strategy are doing so because of a greater awareness in finance and ego. Performing elaborate financial and economic analysis on properties less than 1mm are probably not an efficient use of time, but it's fun for some. If you have experience in valuations, that property value may be 5 or 10mm before slicing data becomes a significant matter. I doubt anyone here is managing a 50m dollar pot, running T-bills through a maturity distribution.

I often found my analysis wasting time, what I mentioned above can be quick especially in a pre-deal situation as to profitability, you just get to a point where you know if a deal is worth your time.

While I have a cost of money, my time and energy is the greatest factor, requiring more than a 20% yield to pay attention to anything as my time being retired is very valuable and can only be rightfully justified posting on Biggerpockets!   :)

Huggy Baird · Answer

I thought i'd post one clarification to my own comment above.  Real estate investors sometimes (albiet rare) do discount cash flows.  However, they are using discount rates like cost-of-capital+required-return.  There is no standard in modern finance for real estate like the CAPM or Fama French three factor model in equities.  The standard for market valuation in real property is comparable sales

Jim Huffman · Answer

Very helpful.  Thanks for laying that out Bryan.  I have been trying to understand DCF vs. Cap Rates. Here is a post that has been somewhat helpful in balancing the two:  http://apartmentpropertyvaluation.com/how-to-use-a-cap-rate

Bryan Hancock · Answer

For bigger properties with stable cash flows you can probably use projections to model things better.  For small properties a lot of this analysis is overkill and stuff is not traded using these techniques.

There are some on BP that take down larger buildings.  Ray Alcorn's material is excellent for learning to display your PFS properly, work with banks, underwrite commercial deals, and put things together.  His article above is only one excerpt of hundreds of pages of top-notch material in his Dealmaker's Guide To Commercial Real Estate.

Note that a proper selection for a discount rate has a lot to do with risk and the investment horizon.  Banks will price their debt accordingly and you should do the same for your equity.  Many projects may command 30% yields with the risk instead of 20%.

Xing Zhu · Answer

Most individuals look for much higher return rate than banks.
A similar situation is that a retail equity trader looks for much higher return rate than hedge funds.

Jack Lee · Answer

Thanks for the replies. Interesting Stuff, especially the derived cap rate.

I was curious because the company I worked for was started by bankers and actually did a lot of DCF for valuations. A lot of software also did DCF analysis so I was curious how they got the discount rates.

This stuff is probably not necessary for small properties. Commercial investors may like to see more detailed analysis like this.

Xing Zhu · Answer

IMO comps work fine in a relatively stable market. In a strong momentum market like now in many cities, simple comps would cost investors immensely in opportunities.

This is what we are hearing now: "anything priced right would get 30-50 offers in two days." IMO, anything getting 30-50 offers in two days  is not priced right.

Huggy Baird · Answer

Hi Jack Lee,

Reading between the lines, since you're using verbiage like "CAPM" and "DCF" it sounds like you are trying to get at present value much more than capitalization rates.  Ultimately you seem interested in asset valuation. I'd offer there are three common methods at valuation:
1. DCF
2. Multiples (eg. Price/Earnings, Price/Sales, Price/Book)
3. Comparable Sale of assets

Typically valuations in real estate are done almost exclusively using "3. comparable sales".  Most of the replies you'll get on BP will reflect this.  Accordingly, that is the reason people talk about cap rates; they are not discounting any cash flows to derive valuations

Now that I got that out of the way.  To address your real question and underscore what others have said in the posts above: It is not easy and there is no industry standard way. In fact, it is not even done in the industry.  If you are running a REIT and are actually tasked with this for a shareholder publication, I'd suggest pulling gross rents and median sale prices from the census. Then you could use the 50% rule of rent (or improve upon it with better assumptions).  This could approximate a true market discount rate of real property for valuation purposes.

If you are not running a REIT and writing a whitepaper on modern portfolio theory for alternative asset classes like real estate, you'll likely find more success as a small real estate investor using "3. comparable sales" and talking the capitalization rate jargon

If you do take on the task of determining the market discount rate, please post your methodology and assumptions; I would be delighted to review and provide feedback

DCF Analysis. How to get discount rate????

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