How do you find a discount rate for a DCF Analysis

Question

Title says it all. How do you find a reasonable discount rate when doing a DCF analysis. Let's take an example where a value-add project is financed:

60% long-term debt. 4.00% 25-year amo. 5-year term.
10% by a junior interest-only loan. 1-year term.
25% is LP equity with a preferred return of 8%.
5% is GP equity.

How would you do it?

Greg Scott · Answer

I've never seen a DCF analysis on a real estate venture, but I suppose the answer depends totally on your perspective, even within the same investment.If I am a young person with not many investment options, my discount rate might be what I can easily get in traditional investments with a risk-adjustment, say something like 5%If I am an accredited investor with access to numerous private deals, I might look at the average of those deals and call that my discount rate, and that might be something like 15%.

Daniel Lozowy · Answer

@Ronald Rohde Exactly! I use it. Probably the best quality for price model you could ever get. The hard thing is choosing the right discount rate, I like the idea of the PwC report @Kevin K. brought up. You can see other investors Required Rate of Return.

Ronald Rohde · Answer

DCF is definitely the more sophisticated approach, there is a good model on adventuresincre.com

Daniel Lozowy · Answer

@kevin @Kevin K. thanks ! I imagine it will be worth it to get the report. Even if it’s expensive

Kevin K. · Answer

Hi Daniel,You can build up a cash flow rate to the equity this way, also know as the cash-on-cash return or equity dividend rate. In fact that’s exactly how they build it. They will show the safe rate 10-year treasury bond, then add additional basis points to account for the risk associated with owning real estate, liquidy risk, management risk, governmental risk, etc. However, this does not account for an investors expected appreciation of the asset. As the formula shows (cap rate + appreciation rate) = internal rate of return <— this is a very simplistic example as there is a ton more information associated with this.That’s why it’s best to see what other market participants are doing and what they’re expections are. For example a lower risk value add project an investor may be comfortable with a 7-9% annualized return or IRR. However, a higher risk repositioning of say and office to residential or something similar may have an investor require a higher return of 12-15%.The same trends follow cap rates. Certain costal cites may have cap rates as low as 4.50%, because investors are expecting some appreciation say 2% and also a certain (low) degree of risk. On the other hand, a class D area that’s known strictly for it’s “cash flow” may have and IRR and cap rate equal to each other at 8%. From the above example we can extract an investor is only willing to take on the additional risk of the class D area, for an extra 1.50% return. However, that is an assumption and only discussions with active market participants can confirm on deny this. See what syndicators on this forum and in your area are showing/offering.I apoligize it’s only PWC now, it started off as Kopaz, then PWC acquired them.

Daniel Lozowy · Answer

Found the PwC survey. Didn’t find anything about Kopaz however

Daniel Lozowy · Answer

@Kevin K. true. Asking investors is a good idea I’ll try that as well. Just for curiosity, Is there a way build the discount rate up from the risk free rate, cost of debt, etc

Kevin K. · Answer

PWC or Kopaz puts out investor survey for expected IRR’s for various property types. Adding some basis points to account for the additional risk given the value add aspect would make sense. If this is not an option I would start asking investors what type of total return you would expect on this type of deal. I’ve commonly seen equity multipliers being used in value add deals, either mentioned by investors desires or even included in offering memorandums. So an example would be I put in $100,000 and get $200,000 backover three years. A 2.0 equity multiplier. A discount rate equivalent would be roughly 33%. We typically see discount rates applied to properties being held around 10 years vs. short term value-adds. Or a conjunction of the two shown above.

Daniel Lozowy · Answer

Good point, I like the difference between new and accredited! It's mainly uses in real estate private equity, but I find it really useful for valuing distressed or value-add deals since the standard cap rate valuation become a bit irrelevant in those cases.