Selecting the appropriate discount rate

Posted On Monday, 24 March 2003 02:00 Published by eProperty News
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As previously stated, the value of a property can be derived by determining the present value of the future income stream. But which discount rate should be used to reduce a future value to a present value?

Jonathan Smith

 

 

 

 

 

 

 

 

 

 

 

 

The discount rate must be considered in the light of the following three factors:

  • The required nominal return of the investor;
  • The anticipated inflation rate during the investment period; and
  • A compensation for the risk that a (property) investor should seek
    as a result of the risk associated with property.

In other words, the discount rate applied to calculate the present value of a future cash stream benefit must compensate the investor for a lost opportunity elsewhere, the negative impact of inflation and the risk that the investor faces through investment in the property.

The extent to which money is accumulated is determined by the rate that an investor obtains from the institution with which the money is invested. The rate at which an investor should discount a future value so as to calculate the associated present value is dictated by the desired real (inflation-adjusted) return of the investor adjusted by a risk-compensation factor. 

Thus, if an investor requires a return of 10% and inflation is projected to be 8% and a suitable risk premium is 3%, the discount rate will be:
Required return + inflation rate + risk premium = discount rate. 

In South Africa, property investors normally use the risk-free return associated with long bonds, such as the RSA153 or RSA157, as therequired return. The inflation is obtained from market analysts with experience in predicting economic cycles and the risk premium (which can be calculated empirically) is derived through calculating the standard deviation associated with the investment. 

A suitable risk premium is between 5 and 7% for property which is directly owned, and 2 and 4% for property which is held in portfolio, including a listed portfolio. If you wish to omit the inflation rate component, you may instead calculate a residual value of the property investment and insert the residual value into the last year of the investment period.

In such instances, your discount rate will only comprise two components: required return and risk premium components. 

Next week, we will focus on the meaning and use of capitalisation rates. 

Last modified on Monday, 30 May 2016 17:08

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