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 as illiquid as residential real estate. The rate of return an investor demands is called a “discount rate.”
The discount rate is different for each investor as each will have different tolerances for risk. During the Great Housing Bubble discount rates on most asset classes were at historic lows due to excess liquidity in capital markets. The discount rate used in the analysis is the variable with the greatest impact on the investment value. Because of the risks of investing in residential real estate, a strong argument can be made that a low discount rate is unwarranted and investors would typically demand higher rates of return for assuming the inherent risks. A low discount rate exaggerates the investment premium and makes an investment appear more valuable, and a high discount rate underestimates 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 it pays a semi-annual interest payment providing a return on the investment. When a TIPS matures, they buyer paid the adjusted principal or original principal, whichever is greater. This is a risk-free investment guaranteed to grow with the rate of inflation. The rate of interest is very low, but since the principal grows with inflation, it provides a return just over the rate of inflation. Houses have historically appreciated at just over the rate of inflation as well; therefore a risk-free investment in TIPS provides a similar rate of asset appreciation as 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. Houses have high transaction costs, and they can be very difficult to sell in a bear market. It is not appropriate to use a 4.5% rate similar to the yield on TIPS or the rate of appreciation of residential real estate as the discount rate in a proper value analysis.
Another convenient discount rate to use when assessing the value of residential real estate is the interest rate on the loan used to acquire the property. Borrowed money costs money in the form of interest payments. A homebuyer can pay down the loan on the property and earn a return on that money equal to the interest on the loan as money not spent. Eliminating 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 dropped below 6%. An argument can be made that 6% is an appropriate discount rate; however, 6% interest rates are near historic lows, and interest rates are likely to be higher in the future. Interest rates stabilized in the mid 80s after the spike of the early 80s to quell inflation. The average contract mortgage interest rate from 1986 to 2007 was 8.0%. If a discount rate matching the loan 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 property to obtain cashflow) typically ignore any resale value appreciation. These investors want to receive cash from rental in excess of the costs of ownership to provide a return on their investment. Despite their different emphasis for achieving a return, the discount rates these investors use may be the most appropriate because it is for the same asset class. Cashflow investors in rental real estate have already discounted for the risks of price volatility and illiquidity. Historically, investors in cashflow producing real estate have demanded returns of near 12%. During the Great Housing bubble, these rates declined to as low as 6% for class “A” apartments in certain California markets. It is likely that discount rates will rise back to their historic norms in the aftermath of the bubble. If a discount rate is used matching that of cashflow investors in residential real estate, a rate of 12% should be used.
Once money is sunk into residential real estate, it can only be extracted through borrowing, which has its own costs, or sale. Money put into residential real estate is money taken away from a competing investment. When buyers are facing a rent versus own decision, they may choose to rent and put their down payment and investment premium into a completely 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-return investment vehicles. An argument can be made that the discount rate should approximate the long-term return on high yield alternative 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 discount rates this high 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 make for low values. The extremes of this range are not appropriate for use because they represent alternatives investments with different risk parameters that are not comparable to residential real estate. The most appropriate discount rates are between 8% and 12% because these represent either credit costs (interest rates) or the rate used by professional real estate investors.