When considering the acquisition of a property, investors need to determine a minimum required return, which then can be used in the analysis of the expected cash flows of the property as the discount rate for estimating the maximum acquisition price that would allow the investor to achieve that minimum required return. In more technical terms, it is the discount rate used to estimate the net present value of the net cash flows of the property over the holding period. This analysis is referred to as the discounted cash flow model.
The minimum required return is also a very useful property investment evaluation tool as it provides a key benchmark for an initial screening of several investment opportunities. Thus, potential investment opportunities that appear from a preliminary analysis not to satisfy the minimum return criterion can be discarded from further consideration allowing the investor to focus on those that seem to satisfy it.
Components of Required Return on a Property Investment
The required return for a property investment has two components: capital return and income return. According to data regarding the investment performance of institutional real estate holdings, the income return for the major property types (apartments, retail, office and industrial) ranges typically between 5-8%. It is calculated as the ratio of the property’s Net Operating Income (NOI) over its purchase price. Capital return is actually the percent change in the value of the property from the time of its purchase until its disposition.
Given the levels of typical income returns that are achievable in the marketplace, annual capital returns of at least 3-6% are required to achieve double-digit returns on property investments. Note also typically upon the resale of the property a sales commission is paid to the agent which means that even a higher annual capital return would be required to achieve real estate returns above 10%.
The capitalization rate, often used in property investment analysis in order to derive a rough estimate of the investment value of a property, is actually a required income return given the capital return expectations of the investors.
How to Estimate a Required Return on a Property Investment
Property investments entail risk and compete in the capital market with both risk-free and other risky investments such as stocks, corporate bonds, etc. According to the Capital Asset Pricing Model (CAPM) the required return for an investment depends on how risky it is. The higher the risk of an investment the higher the required return by investors. Within this framework, a required return on a property investment can be calculated using the following formula:
Required Return = Risk-free rate + Inflation + Risk Premium
The risk free-rate that is typically used for real estate is the 5-year or 10-year government bond due to the long-term nature of property investments. The inflation figure used in the above formula must be the expected inflation over the holding period of the property (not the inflation today, as future inflation maybe different). The risk premium is determined by the investor based on the analysis of the riskiness of the particular asset considered, based on its location and its characteristics.