PROPERTY DISCOUNT RATE

DAN BIHI-ZENOU
 COURSE MAP
Real Estate Fundamentals

Real Estate Financial Mathematics Real Estate as an

Markets for Real Estate Asset Class

Market Valuation (DCF) Real Estate Finance

Property Effect of Leverage Mortgage Refinancing

Cash Flows Cap Rate
Discount Rate on Risk & Return Loan Types Decisions

Investment Analysis

Investment Analysis Leveraged Investment After Tax Investment

without Leverage Analysis Analysis

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LEARNING OBJECTIVES

• Understand how the price determines the total return

• Understand why riskier investments should have a higher discount rate
• Become familiar with the risk premium approach to estimating the property
discount rate

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THE PROPERTY
DISCOUNT RATE
1. Relation between Price & Total Return
2. Discount Rate & Risk
3. Risk Premium-Approach to Estimating the Discount Rate
 FOR WHICH PROPERTY WOULD YOU PAY MORE?
Multi-Family Appartment (Boston) Airport Hotel (Detroit)
$1,50 $1,50
PBTCF in $ mil.

$1,40 $1,40

$1,30 $1,30

$1,20 $1,20

$1,10 $1,10

$1,00 $1,00

$0,90 $0,90

$0,80 $0,80

$0,70 $0,70

$0,60 $0,60

$0,50 $0,50
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Worst case Base case Best Case Worst case Base case Best Case

Expected cash flows are the same

© Ecole hôtelière de Lausanne → DCF cannot account for risk in the cash flows! 5
PRICE & EXPECTED TOTAL RETURN

• Most investors are risk-averse and would pay more for the apartment:
o If price of multi-family apartment: $20.0 million → Total return: 5% (=$1/$20)*
o If price of airport hotel: $12.5 million → Total return: 8.0% (=$1/$12.5)

• Inverse relationship between prices paid today and expected total returns:
o Higher price → lower total return
o Lower price → higher total return

* r=y+g → In this case, the total return is equal to the income return, because growth is 0.
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THE PROPERTY
DISCOUNT RATE
1. Relation between Price & Total Return
2. Discount Rate & Risk
3. Estimating the Property Discount Rates: The Risk
Premium-Approach
HOW TO ACCOUNT FOR RISK IN A DCF?

• Discount Rate
o Rate at which future cash flows are discounted, so the investor gets a fair total
return that compensates him for the risks.
→ DCF accounts for higher risk through a higher discount rate!

• Property Discount Rate

o Discount rate to be used in a market valuation
o Objective and before taking into account leverage and taxes

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THE RISK-RETURN TRADE-OFF

Expected
Return

Risk Premium

risk-free rate

risk

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RISK

• Intuitive meaning of risk:

o Possibility of not making the expected return.

𝑟𝑡 ≠ 𝐸(𝑟𝑡 )

• How to measure risk?

o Range of possible outcomes (e.g. best case / base case / worst case)
o Standard deviation / volatility

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WHAT IS MORE RISKY?

• C is riskier than B
• B is riskier than A
• A is riskless

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STANDARD DEVIATION

σ𝑛𝑖=1 𝑟−𝐸(𝑟) 2
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 (𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛) =
𝑛
• Example
o Best case: r=15%
o Base case: r=5%
o Worst case: r=-5%
15% + 5% + (−5%)
E 𝑟 = = 5%
3

15% − 5% 2 + 5% − 5% 2 + −5% − 5% 2
𝑆𝑡𝑑. 𝐷𝑒𝑣. = = ±8.16%
3

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THE PROPERTY
DISCOUNT RATE
1. Relation between Price & Total Return
2. Risk-Return Relationship
3. Risk Premium-Approach to Estimating the Discount
Rate
WHERE DO DISCOUNT RATES COME FROM?

• Discount rates come from the capital markets

o i.e. competing investment opportunities

Discount Rate = Required Return

= Opportunity Cost of Capital
= Expected total return (p.a.)
=r
= rf + Risk Premium “Risk Premium Approach”
=y+g “Cap Rate Approach”

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THE RISK PREMIUM APPROACH

𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 = 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚

• Risk free rate:

o In a 10-year DCF, rf is typically the 10-year government bond rate
o Current 10-year government bond rate: 2.5%

• Risk Premium:
o Historical average real estate risk premium (without leverage): ~4.5-5.0%
• Core ~1-3%
• Core plus ~3-6%
• Value-add ~6-9%
• Opportunistic ~ >9%
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STABILITY OF THE REAL ESTATE RISK PREMIUM

14%

12%

10%

8%

6%

4%

2%

0%
1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010
10Y Gov. Bond Yield Expected Total Returns (PWC Inv. Survey)

Source: Geltner et al. (2013)

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CONCEPT CHECK

• Calculate the risk premia for the multi-family apartment and the airport hotel
discussed on slides 5&6. Assume that the current yield on 10y US
government bonds is 2.5%.

• Solution:
o Multi-family apartment:
• Total Return: 5%
→ Risk premium: 2.5% (5%-2.5%)
o Airport Hotel:
• Total Return: 8%
→ Risk premium: 5.5% (8%-2.5%)

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 BREAKING DOWN THE RISK PREMIUM

Sector Premium City Premium Property Premium

Asset Class Premium:
~1% for all types of real estate due to
the illiquidity of direct real estate vs.
stocks or bonds.
Real Estate Sector Premium:
~1-2% for real estate sectors with a
higher sensitivity of cash flows to
economic shocks (e.g for hotels vs.
Apartments)
Premium for the Economic Structure
of a City:
~0.5-1.0% for cities with a weak
economic structure focused on only
one industry
~0.5-1.0% for smaller cities with
illiquid real estate markets and a lack
of transparency
Tenant risks
~1% for tenants with insolvency risk
~0.5% for tenant concentration risk
~0.5% for extraordinary right of
cancellation
Building risks
~0.5-1.0% for risks related to the
physical structure of the building

Micro Location
~1-2% for B, C, or D location vs. A
location

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CONCEPT CHECK

• Fill-in the missing numbers according to your estimates

Multi-Family Apartment (Boston) Airport Hotel (Detroit)
Risk-free rate
• 10-year US government bond 2.5% 2.5%

Sector Premium ? ?
• Premium for Illiquidity of Real Estate as an Asset Class ? ?
• Real Estate Sector Premium ? ?

City Premium ? ?
• Economic Structure of the City / Region ? ?
• Size of the real estate market (transparency, liquidity) ? ?

Property Risk Premium 1.0% 1.5%

• Tenant Risk 0.5% 0.0%
• Building Risk 0.0% 0.5%
• Micro Location 0.5% 1.0%
Property Discount Rate 5.0% 8.0%

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CONCEPT CHECK (SOLUTION)

Multi-Family Apartment (Boston) Airport Hotel (Detroit)

Risk-free rate
• 10-year US government bond 2.5% 2.5%

Sector Premium 1.0% 2.5%

• Premium for illiquidity of real estate as an asset class 1.0% 1.0%
• Real estate sector premium 0.0% 1.5%

City Premium 0.5% 1.5%

• Economic structure of the city / region 0.0% 1.0%
• Size of the real estate market (transparency, liquidity) 0.5% 0.5%

Property Risk Premium 1.0% 1.5%

• Tenant risk 0.5% 0.0%
• Building risk 0.0% 0.5%
• Micro location 0.5% 1.0%
Property Discount Rate 5.0% 8.0%

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