Normalized Discount Rates versus Risk-Adjusted Discount Rates
Wincott, D. Richard, Real Estate Issues
The way in which discount rates are selected as part of the appraisal process has been evolving as an issue for some time. Because the discount rate applied in a discounted cash flow (DCF) model actually is the prospective internal rate of return (IRR) for the investment that is being analyzed, questions arise concerning the appropriateness of making inferences from historical rates, such as: What is the current investor thinking regarding investment criteria? Should real estate discount rates move in sync with other indicated capital market yields?
Notwithstanding these issues, it is apparent that the discount rate now used in the majority of appraisal reports represents a proxy that has been obtained from some type of market sampling. This sampling takes various forms: published investor surveys, an average of buyer calculus assumptions from specific transactions and/or the perceived norm for the property type based on the conclusions of a particular appraiser's peer group for a particular month. Whatever their source, the rates inferred from market sampling represent "normalized discount rates" for a property type.
If the purchase of investment-grade real estate, particularly office and retail properties, essentially is an investment in a portfolio of leases, it is reasonable to assume that each property will be unique and that the risk inherent in each lease portfolio will cause rates of return to vary slightly. In essence, elements of risk used in the evaluation of multi-property portfolios also are appropriate to consider in the assessment of risk associated with individual properties. Measurements of the quantity, quality and durability of the income stream to be derived from a lease portfolio should be of significant concern to the appraiser. However, historic rent levels and occupancy rates often are the basis for the appraiser's projections, and these projections do not consider the character of the portfolio in its historic context as compared with current and expected levels of performance.
Property-specific analysis addresses what will be referred to herein as tenant risk. Several elements that influence the extent of tenant risk are inherent in each property or portfolio of leases. A number of these factors typically are addressed in modern portfolio theory in the context of other asset classes. Their application in an analysis of a real estate lease portfolio, in some instances, involves only an alteration of semantics; leases are investment contracts (securities?) that represent the tradeoff between the possession of space and a prescribed income flow.
Four basic areas that affect tenant risk deal with the quality, quantity and durability of the income stream: the diversification of tenants, creditworthiness of tenants, duration of lease terms and size of individual tenants. All of these areas reflect the fundamental risk that can be diversified away with appropriate managerial strategies.
Different industries are affected in different ways by economic cycles. Service firms, such as those involving attorneys and accountants, may fare well during recessionary periods, while manufacturing or retail-oriented businesses may be adversely affected. While there is no definitive index with which to rate the effect of economic cycles on office tenancies in various industrial groupings, analysis of tenant mix in relation to competing properties or the economic base of a city provides insight into probable tenant movement upon lease expirations. The tenant mix by Standard Industrial Classification (SIC) codes forms a basis for this analysis.
Another issue pertaining to tenant mix concerns micro-market characteristics. Many communities typically have a concentration of legal firms in proximity to the courthouse complex. Likewise, office facilities in proximity to hospitals have a propensity to attract doctors, medical labs, etc., as tenants. The inherent risk of investing in buildings that cater to industrial groupings may be viewed in an entirely different light than the risk of investing in typical multi-tenanted, suburban office buildings. …