Weighted Cost of Capital (WACC): Handy Tool or Misleading Metric?

Question

I'm currently learning about the Weighted Cost of Capital (WACC). From what I understand, it is a formula used to determine the true cost (in percentage terms) of financing an investment when using both debt and equity. It is used mostly in the context of corporate investment decisions to determine whether or not a potential investment can provide a significant enough return to account for how much it costs to finance it. But does it apply to real estate investing? Could it help an investor to decide whether or not a property is worth considering?

Frank Jiang · Answer

WACC is an internal measure of your borrowing costs.  It's not meant to be used to determine property value.  What you do use it for is determining the IRR of your investment.

It is also the minimum necessary return that your project must achieve to breakeven.

Your goal is to widen this gap between your cost of capital and the project return as much as you possibly can.

Scott Jensen · Answer

@Ryan J Bruun  WACC isn't a good metric for evaluating whether a property is worth it or not.  WACC is a good metric for determining the costs associated with using partners (Equity) vs lenders (Debt).

Frank Jiang · Answer

Second post to the same topic to add clarity.

You are correct in that the way all of these comparison calculations work are all incredibly similar, but it seems like you're not super clear on when to use these different rates and their interaction with each other.  Here's a little more info that should help clarify the differences.

- Risk Free Rate: when you compare your deal against Rf, this is the risk-free-rate-adjusted return of the deal.  Since Rf is commonly either inflation or t-notes or something, what this most accurately represents in layman terms is your inflation-adjusted rate of return.  You can't simply say "I could invest in another real estate deal at 10%, so my Rf is 10%".  That doesn't make sense since that investment is not risk free.  You are referring to Opportunity Cost when you say that.  I personally find the risk free metric to be mostly useless.

- Cost of Capital: when you compare your deal against WACC, this is return rate of your equity within an individual deal, after factoring out the payback of all debts and equity partners

- Opportunity Cost: when you compare your deal against the opportunity cost of similar deals or any other investment you could potentially make, this tells you whether or not it makes sense from a pure return perspective to invest in one type of asset or another.

Super basic example below where you buy a 10% return property, and take out a 4% loan at 60% LTV and gather equity for a portion of the remainder 25% of value @ 8% and then comparing the return of your equity against inflation and an opportunity cost investment such as the stock market returning 7%:

Note that you compare the rf or inflation and the opportunity cost against your personal equity contribution.  Note that the most important number here is the 37% personal return on your own equity.

That rate of return is 35% when adjusted for inflation and 28% better than investing in the stock market over the same period, but really... who cares?  This is just spreadsheet shenanigans and has little bearing on your decisions for making or managing a deal in the real world.

Ryan J Bruun · Answer

@Frank Jiang

Thank you so much for your extremely informative replies. I read through your longer post six or seven times and its starting to make sense to me. I agree with your statement that if Rf is just adjusting for inflation then it's a pointless metric- I could just subtract 2% from my gross return. I definitely got Rf and Opportunity Cost confused there, so thanks for setting me straight.

Your spreadsheet at the end (even if it is oversimplified) opened my eyes to the power of using private equity in your investments, although I imagine it comes with its own risks. It almost seems to me like you're calculating cash-on-cash, and just showing the steps that got you there. Even so, very enlightening.

Your reply prompted me to do some more learning about WACC and I came up with a couple more questions. For starters, how would a potential investor go about determining their required rate of return for a piece of real estate? Unlike the stock market, there isn't a great way to quantify risk in real estate. Would it be reasonable to assume that private investor's required rate of return would be equal to the opportunity cost of investing in the stock market (7%), or whatever other investments that particular investor may be considering?

Ryan J Bruun · Answer

@Scott Jensen I hear what you're saying. I think that maybe the metric could be modified a bit to make it applicable to the individual investor. Instead of the cost of equity representing the required rate of return that a potential partner would require, it could be substituted for the risk-free return that could be achieved on an individual's cash. For example, if you could get a risk free return of 10% on your cash over the next year in some investment or another, then the real estate investment would have to provide a return that accounts for this. I understand this is straying into the territory of discount rate, but I think that the WACC formula itself puts the investor in the right mindset of being aware of the cost of debt and the opportunity cost of any cash spent on the deal.

Weighted Cost of Capital (WACC): Handy Tool or Misleading Metric?

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