When considering the acquisition of a property, investors need to determine a minimum required rate of 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 rate of return. In more technical terms, the required rate of return is the discount rate used to estimate the net present value of the net cash flows of a property over the holding period. This analysis is referred to as the discounted cash flow model.
The minimum required rate of 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 Rate of Return on a Property Investment
Other Performance Measures
How to Calculate a Leveraged IRR
IRR or MIRR? Which one should you Use?
How to Estimate the Recapture Premium for your Property Investment
Capital Return: The Key for Double-Digit Returns
Return on Equity: Is this an IRR?
Cash-on-Cash Return: The Least Uncertain
The required rate of 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. The 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 that typically upon the resale of a property a sales commission is paid to the agent which means that an even 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 Calculate a Discount Rate for a Property Investment
As indicated earlier the required rate of return is actually the discount rate used to calculate the NPV of the net cash flows of a property. 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 rate of return on an investment depends on how risky it is. The higher the risk of an investment the higher the required rate of return by investors. Within this framework, a required return on a property investment or the discount rate can be calculated using the following formula:
Required Rate of Return or Discount Rate = Real Risk-free rate + Inflation + Risk Premium
The risk free-rate that is typically used for real estate is the interest rate offered by long-term government bonds, as it is considered that the risk of defaulting on those bonds by a government of a country is zero. Of course this was the prevailing perception before the global financial crisis of 2008 and the haircut of Greek government bonds. However, despite some general scepticism, government bond interest rates are still considered the best proxy for the risk-free rate. To calculate the real risk-free rate simply deduct from the risk-free rate the current inflation rate.
The second term of the formula, the inflation rate, must be the expected inflation over the holding period of the property and not the inflation rate at the time of analysis, since future inflation maybe different. Thus a reliable average inflation forecast for the next five years should be used in the above formula.
Finally, the risk premium is determined by the investor based on the analysis of the riskiness of the particular asset considered, based on its submarket, city and country location as well as all the characteristics of the property considered (age, size, design, functionality, amenities, etc.). For example, a 20-year old property should be assigned a higher risk premium compared to a just-completed property, due to physical and functional depreciation and the risk of higher maintenance and other expences. Similarly, an income-producing asset at a prime location should be assigned a lower risk premium compared to an income-producing asset at a secondary or tertiary location.
The required return formula and almost all the formulas presented and discussed in our website are included in the completely FREE 48-page e-book Real Estate Mathematics, which you can download at this link (no email address or anything else will be asked of you).
References
Kolbe, P. T., & Greer, G. E. (Author), Gaylon E. Greer. (2012). Investment Analysis for Real Estate Decisions, 8th Edition. Dearborn Real Estate Education.
Sivitanides, P. 2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing.
Geltner, M., Miller, N. G., Clayton, J., & Eichholtz, P. (2013). Commercial Real Estate Analysis and Investments (with CD-ROM). Oncourse Learning
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