What Type Of Account Is Additional Paid-In Capital Treasury Stock The Appropriate Discount Rate For Residential Real Estate Analysis

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The Appropriate Discount Rate For Residential Real Estate Analysis

The investment value of a property can only be measured against other investment opportunities available to the investor. If investors can earn 4.5% investing in government Treasuries, they will demand a higher rate of return to invest in an asset as volatile and illiquid as residential real estate. The rate of return required by the investor is called the “discount rate.”

The discount rate is different for every investor as everyone will have different risk tolerances. During the Great Housing Bubble, discount rates for most asset classes were at historic lows due to excess liquidity in the capital markets. The discount rate used in the analysis is the variable that most affects the value of the investment. Because of the risks associated with residential real estate investing, a strong argument can be made that a low discount rate is unwarranted, and investors typically demand higher rates of return while accepting the inherent risks. A low discount rate overstates the investment premium and makes the investment more valuable, while a high discount rate understates the investment premium and makes the investment less valuable.

The US Treasury sells a product called Treasury Inflation-Protected Securities (TIPS). TIPS principal increases with inflation, and it pays semiannual interest, providing a return on investment. When the TIPS matures, the buyer pays the adjusted principal or original principal, whichever is greater. It is a risk-free investment that is guaranteed to grow with the rate of inflation. The interest rate is very low, but since the principal increases with inflation, it provides a return that is slightly higher than the rate of inflation. Homes have also historically appreciated slightly above the rate of inflation; therefore, a risk-free investment in TIPS provides the same rate of growth in asset value as residential real estate (approximately 4.5%). Despite their similarities, TIPS are a much more desirable investment because the value is not very volatile and TIPS are much easier and cheaper to buy and sell. The cost of residential real estate is known to be volatile, especially in coastal regions. Homes have high transaction costs and can be very difficult to sell in a bear market. It is inappropriate to use a rate of 4.5%, similar to the yield on TIPS or the rate of appreciation of residential real estate, as a discount rate in a proper value analysis.

Another convenient discount rate when evaluating the value of residential real estate is the interest rate on the loan used to purchase real estate. Borrowed money costs money in the form of interest payments. A homebuyer can pay off the loan on the property and earn a return on that money equal to the interest on the loan as money that was not spent. The elimination of interest expense provides a return on investment equal to the interest rate. During the Great Bubble, interest rates on 30-year fixed-rate mortgages fell below 6%. An argument can be made that 6% is an appropriate discount rate; however, interest rates at 6% are close to historic lows, and interest rates are likely to be higher in the future. Interest rates stabilized in the mid-80s after a spike in the early 80s to stem inflation. The average interest rate on contract mortgages from 1986 to 2007 was 8.0%. If the value analysis uses a discount rate that corresponds to the interest rate of the loan, it is more appropriate to use 8% than 6%.

Residential real estate investors (those who invest in rental properties for cash) typically ignore the increase in resale value. These investors want to generate rental cash in excess of the cost of ownership to ensure a return on their investment. Despite their different emphasis on yield, the discount rates used by these investors may be the most appropriate because they belong to the same asset class. Cash flow investors in rental properties have already given up on the risks of price volatility and illiquidity. Historically, cash-generating real estate investors have required a return of about 12%. During the Great Housing Bubble, these rates dropped to 6% for Class A apartments in some California markets. After the bubble, discount rates are likely to return to their historical norms. If a discount rate is used that matches the cash flow rate of residential real estate investors, a rate of 12% should be used.

When money is invested in residential real estate, it can only be obtained by borrowing, which has its own costs, or by selling. Money invested in residential real estate is money withdrawn from competing investments. When buyers are faced with a rent-to-own decision, they can choose to rent and put their down payment and investment premium into an entirely different asset class with even higher returns. This money can go into high-yield bonds, market index funds or mutual funds, commodities, or any of a variety of high-risk, high-return investment vehicles. An argument can be made that the discount rate should approach the long-term rate of return on high-yield alternative investments, perhaps 15% or 18%. While an individual investor may forgo these investment opportunities to purchase residential real estate, it is inappropriate to use such high discount rates because many of these investments are riskier and more volatile than residential real estate.

The discount rate is the most important variable in assessing the investment value of residential real estate. Arguments can be made for rates between 4.5% and 18%. Low discount rates mean high values ​​and high rates mean low values. The extremes of this range are not suitable for use because they represent alternative investments with different risk parameters that are not comparable to residential real estate. The most appropriate discount rates are between 8% and 12% because they represent either the cost of credit (interest rates) or the rate used by professional real estate investors.

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