When deciding whether to invest in a property, investors need to calculate not only how much the property is worth now, but how much it will be worth in the future. The difference of just a couple of years in a property’s viability can determine if an asset will meet your business goals. To make your decision, you need to choose an appropriate discount rate and begin your cash flow analysis — only then can you decide whether a property’s value is worth your time and effort.
What is the Discount Rate?
In investment banking, the discount rate has two meanings. One is the interest rate charged to commercial banks for loans taken out of the Federal Reserve. The other is the interest rate used in discounted cash flow analysis for calculating an investment’s current value and future cash flows.
This second definition is what investors and investment firms use to decide which assets to take up to grow their holdings. Discounted cash flow analysis relies on the interest rate used to determine an investment’s present value and potential to make money in the future. A higher discount rate leads to a low present value, while a lower discount rate leads to a high present value.
Discount Rate in Commercial Real Estate Investments
Discount rate can determine if any asset is a reasonable investment through a future-forward lens. This is especially important in the real estate market that relies on potential value assessment to anticipate the worth of a particular investment interest.
Since discount rate can impact the net present value of a property, it’s important to choose the right number for your calculations. For commercial real estate, you need to choose a discount rate that reflects the opportunity cost of putting money in a different investment. For example, an investor can choose a discount rate that matches the rate of return that could be earned through a different property currently on the market of similar size and risk.
Discount rate is always dependent on NPV, so take into account the property characteristics, the macroeconomic situation of the property’s location, and any other risks that come up in effective property valuation, such as market direction and lease expirations.
Discount rates are used in assessing investment properties to determine the viability of cash flows and present and future values. By understanding how this rate of return will influence your investment aspirations, you can choose the right properties to buy for future profit.