The investment value of a property can only be measured against other investment opportunities available to an investor. If investors can earn 4.5% by investing in government Treasuries, they will demand a higher return to invest in an asset as volatile and illiquid as residential real estate. The rate of return 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 in most asset classes were at record lows due to excess liquidity in the 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 argued strongly that a low discount rate is not justified and that investors would normally demand higher rates of return for assuming the inherent risks. A low discount rate overstates the investment premium and makes the investment appear more valuable, and a high discount rate understates the investment premium and makes the investment appear less valuable.
The US Treasury Department 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. This is a risk free investment guaranteed to grow with the rate of inflation. The interest rate is very low, but since the principal grows with inflation, it provides a return just above the rate of inflation. Historically, houses have also appreciated somewhat above the rate of inflation; therefore, a risk-free investment in TIPS provides an asset appreciation rate similar to 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 residential property appreciation rate as a 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 loan on the property and earn a return on that money equal to the interest on the loan as unspent money. Eliminating interest expense provides an investment return 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 appropriate discount rate; however, 6% interest rates are near record lows and interest rates are likely to be higher in the future. Interest rates stabilized in the mid-1980s after peaking in the early 1980s to stifle inflation. The average mortgage interest rate on the contract from 1986 to 2007 was 8.0%. If a discount rate that matches the interest rate on the loan is used in a value analysis, 8% is more appropriate than 6%.
Residential real estate investors (those who invest in rental properties for cash flow) generally ignore any resale value appreciation. These investors want to receive rental cash on top of property costs to get a return on their investment. Despite their different emphasis on achieving a return, the discount rates used by these investors may be the most appropriate because they are dealing with the same asset class. Cash flow investors in rental real estate have already priced in the risks of price volatility and illiquidity. Historically, cash flow-generating real estate investors have demanded returns close to 12%. During the Great Housing Bubble, these rates were lowered to a minimum of 6% for Class “A” apartments in certain California markets. Discount rates are likely to rise back to their historical norms after the bubble. If a discount rate equivalent to that of residential real estate cash flow investors is used, a rate of 12% should be used.
Once the money is invested in residential real estate, it can only be extracted through loans, which have their own costs or sale. Money put into residential real estate is money taken away from a competing investment. When faced with a rental versus ownership decision, buyers may choose to rent and put their down payment and investment premium into an entirely different asset class with even higher returns. This money could go into 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 on 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 not appropriate 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 evaluating the investment value of residential real estate. Arguments can be made for rates as low as 4.5% and as high as 18%. Low discount rates translate to high values, and high rates generate low values. The extremes 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 appropriate discount rates are between 8% and 12% because they represent either the costs of credit (interest rates) or the rate used by professional real estate investors.
