The investment value of a property can only be measured against other investment opportunities available to an investor. If investors can earn 4.5% investing in government bonds, they will demand a higher return to invest in an asset as volatile and as illiquid as residential real estate. The rate of return that an investor demands is called the “discount rate.”
The discount rate is different for each investor, as each will have different risk tolerances. During the Great Housing Bubble, discount rates for most asset classes were at record lows due to excess liquidity in capital markets. The discount rate used in the analysis is the variable with the greatest impact on the value of the investment. Due to the risks of investing in residential real estate, it can be strongly argued that a low discount rate is not justified and investors would normally demand higher rates of return for taking the inherent risks. A low discount rate exaggerates the investment premium and makes an investment appear more valuable, and a high discount rate understates the investment premium and makes an investment appear less valuable.
The US Department of the Treasury sells a product called Treasury Inflation Protected Securities (TIPS). The principal of a TIPS increases with inflation and pays a semi-annual interest payment that provides a return on investment. When a TIPS expires, the buyer pays the adjusted principal or the original principal, whichever is greater. It is a risk-free investment that guarantees growth with the rate of inflation. The interest rate is very low, but since principal grows with inflation, it provides a return just above the inflation rate. Historically, houses have also appreciated at a rate slightly above the rate of inflation; therefore, a risk-free investment in TIPS provides an asset appreciation rate similar to that of 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 less expensive to buy and sell. Residential real estate values are notoriously volatile, particularly in coastal regions. Homes have high transaction costs and can be very difficult to sell in a bear market. It is not appropriate to use a 4.5% rate similar to the TIPS yield or the residential real estate appreciation rate as the discount rate in a proper value analysis.
Another convenient discount rate to use when evaluating the value of residential real estate is the interest rate on the loan used to purchase the property. Borrowed money costs money in the form of interest payments. A home buyer can pay off the property loan and earn a return on that money equal to the interest on the loan as unspent money. Elimination of interest expense provides a return on investment equal to the interest rate. Interest rates during the Great Housing Bubble on 30-year fixed-rate mortgages fell below 6%. It can be argued that 6% is an adequate discount rate; however, 6% interest rates are close to historic lows and interest rates are likely to be higher in the future. Interest rates stabilized in the mid-1980s after the spike in the early 1980s to quell inflation. The average interest rate on mortgage contracts from 1986 to 2007 was 8.0%. If a discount rate that matches the loan’s interest rate is used in a value analysis, it is more appropriate to use 8% than 6%.
Investors in residential real estate (those who invest in rental properties for cash flow) generally ignore any appreciation in resale value. These investors want to receive rental cash that exceeds the costs of ownership to provide a return on their investment. Despite their different emphasis on achieving a return, the discount rates these investors use may be most appropriate because they are for the same asset class. Cash flow investors in rental properties have already discounted the risks of price volatility and illiquidity. Historically, cash flow investors producing real estate have demanded returns close to 12%. During the great housing bubble, these rates fell as much as 6% for Class “A” apartments in certain California markets. Discount rates are likely to rise back to their historical norms after the bubble. If using a discount rate that matches that of residential real estate cash flow investors, a rate of 12% should be used.
Once the money is invested in residential real estate, it can only be extracted through a loan, which has its own costs, or through sale. The money invested in residential real estate is the money that is taken out of a competing investment. When buyers are faced with a rental decision versus their own decision, they can choose to rent and place their down payment and investment premium in an entirely different asset class with even higher returns. This money could go to high-yield bonds, market index funds or mutual funds, commodities, or any of a variety of high-risk, high-yield investment vehicles. It can be argued that the discount rate should approximate the long-term return of alternative high-yield investments, perhaps as high as 15% or 18%. Although an individual investor may forego 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 properties.
The discount rate is the most important variable in evaluating the investment value of residential properties. Rates as low as 4.5% and as high as 18% can be argued. Low discount rates translate to high values and high rates generate low values. The ends of this range are not appropriate for use because they represent alternative investments with different risk parameters that are not comparable to residential real estate. The most suitable discount rates are between 8% and 12% because they represent credit costs (interest rates) or the rate used by professional real estate investors.