A discount rate, for purposes of real
estate investment analysis, is best
described as the cost of lost opportunity.
In other words, an investor invests in one
property at the expense of not having
invested in another. If prevailing
investments with similar risk provide a 9.5%
rate of return, then the opportunity cost of
that money is 9.5% when pursuing an
alternate investment.
Components
The discount rate takes into account the
opportunity cost (often referred to as the
hurdle rate ), and is, in effect, a
predetermined benchmark rate of return. The
discount rate need not always align with the
opportunity cost. Often the rate based on
lost opportunity merely represents a minimum
cost. The investor may perceive an
additional risk for a given investment
option and add a risk premium to that rate.
The discount rate is used in determining
the present value of future cash flows and
is an integral aspect of capital budgeting
and asset selection criteria. For real
estate capital assets, the discount rate is
applied to operations and sale proceeds cash
flows over a specified holding period. The
resulting discounted cash flows can lead to
investment comparisons and/or estimates of
value. Commercial practitioners most
commonly discount cash flow after tax to
arrive at investment value based on the
goals and objectives of a specific investor.
In real estate, investors and
practitioners typically work with a hurdle
rate that represents both opportunity cost
and risk. The opportunity cost is usually
derived from the marketplace by weighing out
differing investment vehicles that possess
similar risks, capital requirements, and
holding periods. The resulting discount rate
provides the basis to analyze cash flows and
arrive at present values.
Risk-Adjusted Cost of Capital
Corporations often establish a discount
rate through the risk-adjusted cost of
capital, (Example 2). The rate reflects at
minimum the costs associated with obtaining
capital from various classes of investors. A
weighted cost is established based on
prorating in relation to those sources.
Corporations typically raise capital through
three avenues: mortgage debt, preferred
shares, and common shares. The proportionate
contribution of each (based on an after tax
perspective), is used in arriving at the
final cost.
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