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This question has two parts.
1. In topic 2.7, you note the following: “Compare the assumed cap rate to the prevailing risk-free rate (USTs in the United States) and market discount rates. Know the spread between each and ask yourself, is this appropriate and/or likely to persist?”
Can you explain that further?
2. In the Cornell Real Estate Journal article on cap rates that you posted, cap rate is broken down into the following equation:
R = r – g
R = Cap Rate
r = discount rate
g = assumed growth rateMy question pertains to discount rate (r). Specifically, the journal article notes that the discount rate (r) is equal to a risk free rate plus a premium for risk. In other words:
r = 10 year treasury + risk premium.
Can you explain how one might calculate an appropriate risk premium?
Thank you.
Two excellent questions. They are related, so let me see if I can answer both questions at once.
The idea is this. At any time, an Investor can purchase a “risk-free” and completely liquid asset in the form of a government bond. That government bond will offer some yield-to-maturity that in finance is called the “risk-free rate”. When an investor is deciding whether to make an investment, that risk-free option is always available to him as the safest alternative. Thus, the investor would expect some yield premium to invest in any asset that is riskier than the “risk-free” government bond.
That same principle applies to real estate. Because real estate is riskier than government bonds, the real estate investor would expect the return on a real estate investment to be higher than the yield on a government bond. That is the “risk premium” referred to in the Cornell Real Estate Journal article, and what I was stating when I said: “Compare the assumed cap rate to the prevailing risk-free rate (USTs in the United States) and market discount rates. Know the spread between each and ask yourself, is this appropriate and/or likely to persist?”
As a side note. This “risk premium” is a metric that mostly institutional real estate investors track (see the CBRE Cap Rate Survey for the avg. risk premium by property type and location). If the real estate risk premium (difference between risk free rate and cap rates) narrows, that means real estate investors are willing to take more risk for less return; which is generally due to a greater supply of real estate capital chasing fewer opportunities.
So how does one go about “calculating” the risk premium? In the real world, you don’t! The market sets the risk premium and it’s up to you to decide whether that risk premium is enough. In other words, the market may offer you opportunities to buy at a 6% cap rate, resulting in an 8% unlevered IRR (i.e. the discount rate – see course 2) and it’s up to you whether that’s a sufficient return to justify the commensurate risk. And that decision – whether the return is sufficient – is most often decided by your debt and equity capital sources.
As an example, imagine prevailing cap rates are 4% for your property type and market of choice and you expect to yield a 6% unlevered IRR when taking into account growth. However, you seek out a 60% LTV loan and quotes come back at a 6% interest rate. And when you go to your equity partner, they quote you an 8% preferred return to cover the other 40%. You can thus safely say that the return doesn’t justify the risk, because the capital markets (debt and equity providers) told you so.
With all of that said, in the spirit of teaching what really goes on in the industry, this is not that important in the grand scheme of things! It’s good to know so you understand what’s driving cap rates and discount rates, but it’s not like real estate analysts or associates are using a complex formula to calculate the appropriate risk premium to apply to each deal. The deal tells you the risk premium, and it’s up to you to decide whether that’s sufficient.
Michael goes into this in more depth in course 2 when discussing discount rate, unlevered IRR, PV calculation, and how they are all used in practice.
Thanks again for the great questions!
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