Discount rate in property valuation is a key assumption and impacts the valuation significantly. Finding the appropriate discount rate for a specific property is a bit tricky.
In this post I will discuss the impact of discount rate in the property valuation and look at how to get it right.
There are various valuation methodologies for the valuation of real estate properties. Discounted cash flow analysis, Capitalization method and comparable method are the three main valuation methodologies used for property valuation.
The comparable valuation method is also called comparable sales approach. It is a relative valuation tool, and the specific property valuation is benchmarked by identifying recent transactions of comparable properties. This valuation method is mostly used as a sense check rather than to determine the actual value of the property.
Capitalization method is a cap rate approach to valuation.
Cap rate is the ratio between the net operating income produced by an asset and its capital cost. It is not a truly relevant indicator for a development project. It is used in project feasibility study to find the exit value of the project i.e., capitalized sale value.
The capitalization method is useful for quick comparison of the relative values of similar properties. Though it should not be used as the sole indicator of property value as it does not consider the capital structure, the time value of money and additional future cash flows from the property upgrades.
Discounted cash flow (DCF) method is a more robust property valuation methodology. This valuation methodology takes into account the capital structure, the time value of money and additional future cash flows from the property upgrades. The DCF model allows us to project the revenue, expenses, and cash flows for the entire estimated hold period of the property.
DCF valuation requires forecasting the future cash flows over the assumed holding period, along with the terminal value at the end of that period by capitalizing the last year net operating income. The net cash flow is then discounted to the present day at a discount rate that reflects the perceived level of risk.
The discount rate will reflect market and property-specific risks. You should be careful not to reflect risk factors in both the cash flow and the discount rate.
Discount rate is a financial concept that is used to determine the present value of a future payment or series of payments, considering the time value of money and the required rate of return for an investment. It is an important tool for financial analysis and decision-making and is used in a variety of financial calculations.
To perform a DCF valuation, you must first forecast the future cash flows of the investment. This typically involves making assumptions about the rate of growth in revenues and expenses, as well as the required rate of return. Once these projections have been made, you can use a discount rate to "discount" the future cash flows back to their present value.
It is important to note that the accuracy of a DCF valuation is highly dependent on the assumptions made about future cash flows and the discount rate. If the assumptions are overly optimistic or the discount rate is too low, the resulting valuation may be too high. Conversely, if the assumptions are too conservative or the discount rate is too high, the valuation may be too low.
For property valuation, we should be using the weighted average cost of capital (WACC) as discount rate. WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight and then adding the products together.
Now let’s examine the impact of discount rate on the DCF valuation.
Assume that we have a property for which we have forecasted the Net Operating Income and also terminal value has been calculated by using a benchmarked cap rate.
We find the present value of the future net operating income by using 10% discount rate:
The value at 10% discount rate is 1,397,988.
Now let’s explore the impact of various discount rates of the valuation:
You can notice that every 1% increase in discount rate decreases the property value by roughly 6%.
Hope you enjoyed this post on discount rate in property valuation, let me know what you think in the comment section below.
Also, you can download the Excel file from the below link to explore the relation between discount rate and valuation.
About the Author
With a background in engineering and finance, have handled projects in varied geographies including UAE, Qatar, Oman, UK, Fast East and Eastern Europe
Responsible for delivering financially viable projects
200+ projects covering almost every real estate asset classes
Total area of completed and running projects is in excess 2,500,000 sqm
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