Words matter. Sometimes they matter a lot, especially in real estate investing. Take, for example, words investors use to describe how investments are performing. Terms like cap rate, risk premium, and IRR calculation don't mean a lot to people outside the investing world, but within it, they pack a huge informational punch.
The discount rate in real estate is no different. It's a commonly misunderstood, underappreciated term that more rental property investors would benefit from learning more about.
Like the cap rate, the discount rate can help you determine if the rental property or other investment property you're buying is worth what you're paying for it. That's a pretty useful piece of information if you want to make money with your real estate asset. That's not to say that you can't make money without understanding the discount rate bit, but having the whole picture sure helps grease the track.
The discount rate explained (in English)
Put extremely simply, the discount rate is how much you'd have to discount your real estate investment after a given number of years to make that number match today's money. So, say you have a parcel of commercial real estate that you expect will be valued at $105 at the end of a year with a 5% discount rate. That means that your equivalent dollar value for that property today is $100, since it's expected to grow 5% during the year to a value of $105.
The discount rate is all about walking back investment projections to today, day one of your investment, to determine the property's present value as an investment asset.
Generally, in practice, the discount rate is used to calculate multiple years of discounts. Very few people buy investment properties looking only to the year ahead. This is different from the capitalization rate, which generally only looks at a single year's net operating income. While you may be able to calculate returns with a cap rate, you can't work backward and determine a property value, for example, because a cap rate takes a very short-term view.
How to determine the discount rate
The discount rate can be determined in one of a couple of ways. The first, and often most popular, is by literally setting it to the investor's required rate of return. So, if you require a 5% return on a property and you believe the value of that property will be $105 at the end of your year, you know you simply cannot give more than $100 for it. That's pretty simple stuff if you know your market well and can accurately anticipate the future cash flow or future value of properties like yours (hopefully they're worth more than a Benjamin!).
Another way to figure out a discount rate is by looking at another real estate investment similar to yours and its performance. Because no real estate investment opportunity is identical to another in absolutely every way, using this opportunity cost method to determine the discount rate is a bit of a wobbly noodle.
It's a lot like getting an appraisal for real estate valuation: You can look at similar properties to see what they've sold for, add and subtract features, but at the end of the day, it's still a best-guess scenario. It's usually a pretty good best guess and one that's dripping with research, but because no single property is exactly the same as the next, there will always be variables you can't fully account for in determining market value.
For larger investors, like institutional types, the discount rate that's generally used is based on the weighted average cost of capital (WACC). That's a figure that takes into account all the capital sources used to finance a given investment and the interest rate of each, with each source weighted appropriately and a whole lot of variables considered on an individual basis. They can still be strikingly wrong if the economy slides sideways or an unexpected upheaval occurs in the industry the property is involved with -- in these cases, all the math in the world still won't guarantee a hit in the end.
The Millionacres bottom line
What we've discussed here is a very simplistic way of looking at discount rates, just for the sake of definition and understanding the concept as it relates to property valuation. One thing we didn't go over was how risk works into the numbers.
Generally speaking, if the risk of the project or acquisition is high, you'll be looking at a higher discount rate. If the risk is low, you'll be looking at a smaller discount rate. That also means that over time, your value will grow more slowly, but you're also less likely to lose any part of your investment, which is a really lovely thing.
Understanding what an appropriate discount rate is and how to use it is pretty important when you're making an initial investment. This is especially true if you can count on the person doing the research and the math to give you accurate figures, either on similar property discount rates or on other factors that can help get you there, like income, expenses, equity growth, and so on.
It's not strictly necessary to use the discount rate when determining how much you'll be willing to invest in a property, but I'd bet you generally do a shorthand version of this in your head anyway to determine future value. You might ask yourself: If I spend X dollars on the property that cost me Y amount (including operating expenses) and the income stream increases every year at Z percent, what do I have when I'm ready to sell in a decade, and how much am I willing to give for that investment's overall return?
In short: Even if you weren't familiar with the concept of discount rates, you may find you've been using them all along.