Introduction
Proper valuation is essential for making informed investment decisions. This article explores the concept of using three distinct discount rates to assess the long-term cash flow of a commercial property, each addressing different components of its projected cash flow.
Discount Rate
The discount rate is the rate of return used to discount future cash flows back to their present value. It reflects the time value of money and the risks associated with the property’s future income. The choice of discount rate can significantly impact the valuation of a commercial property, particularly when considering long-term investments.
The Three Discount Rates for Valuation
When evaluating a commercial property, the discount rate may be applied to the following three sets of projected cash flow:
Cash Flow from Existing or Signable Lease
Speculative Cash Flow Post-Lease Expiration
Residual Value at Disposition
Each piece addresses different aspects of the property’s cash flow and risk profile, requiring a tailored approach to determining the appropriate discount rate.
1. Cash Flow from Existing or Signable Lease
The first discount rate pertains to the cash flow of the existing or signable lease. This part of the discount rate is typically based on the tenant’s creditworthiness, as the tenant’s ability to meet lease obligations is crucial to the property’s income stability.
Tenant Credit Rating: For publicly traded tenants, credit ratings from agencies like Moody’s or Standard & Poor’s indicate the tenant’s creditworthiness. For private tenants, evaluating creditworthiness requires a more nuanced approach. Resources like Spenser Burton’s article on underwriting tenant private credit ratings can offer valuable insights into assessing the risk associated with private tenants.
Bond Yield Equivalent: A common practice is to use a bond yield equivalent to determine the discount rate for this cash flow. This approach aligns the discount rate with the tenant’s perceived risk in the bond market, providing a reasonable basis for valuing the in-place lease cash flow.
2. Speculative Cash Flow Post-Lease Expiration
The second discount rate addresses the speculative cash flow that may be generated after the current lease expires. This period introduces additional risk, as future market conditions and tenant occupancy are uncertain.
Margin for Speculation: Given the speculative nature of this cash flow, it is prudent to apply a higher discount rate depending on the property type or intended future tenants to account for the increased risk. This higher rate acts as a margin of safety, compensating for the uncertainties inherent in projecting future income streams.
Market Conditions and Lease Renewal: The likelihood of lease renewal, the potential for tenant turnover, and future market conditions all play a role in determining this part of the discount rate. An overly optimistic assumption could lead to an inflated property valuation, while a conservative approach helps safeguard against future volatility.
3. Residual Value at Disposition
The third discount rate relates to the residual value of the property at the time of disposition. This value is essentially the projected sale price of the property at the end of the investment horizon.
Cap Rate Application: A common method for estimating the residual value is to apply a current market cap rate to the projected NOI at the time of sale. However, it’s important to consider that market conditions can change significantly over time, making this projection inherently uncertain.
Spread to Cap Rate: To account for this uncertainty, a spread should be applied to the current market cap rate when determining the discount rate for the residual value. This spread compensates for the unpredictability of future market conditions and macroeconomic trends, providing a more conservative estimate of the property’s value at disposition.
Application: Net Present Value and Implied Cap Rate
Applying the three discount rates to the respective cash flows (existing tenant leases, speculative post-lease cash flow, and residual value) results in the property’s Net Present Value (NPV). This NPV represents the sum of all future cash flows discounted back to their present value using the three discount rates.
Implied Combined Cap Rate: The NPV and the property’s current NOI or a stabilized market NOI calculate an implied combined cap rate. This cap rate indicates how the property’s valuation compares to similar properties or how it reflects the creditworthiness of the tenants.
For example, a lower implied cap rate than appropriate comparables might suggest that the property is valued higher due to the strong creditworthiness of the tenants, while a higher implied cap rate could indicate a higher perceived risk, possibly due to speculative future cash flows or market uncertainties.
Conclusion
Applying the three discount rates to the cash flows of a commercial property provides a more nuanced valuation. By addressing the in-place leases, speculative post-lease cash flow, and residual value separately, investors can better assess the risks and returns associated with the property. Whether dealing with public or private tenants, using the appropriate discount rates for each cash flow set is essential for making informed and prudent investment decisions.
References
Burton, Spenser. “Underwriting Tenant Private Credit Ratings.” Adventures in CRE, 2023.
Burton, Spenser. “Single Tenant NNN Lease Valuation Model.” Adventures in CRE, 2023.
Comments