Determining Discount Rates?
When you are tasked with choosing a discount rate for the DCF analysis of a project, what are your key considerations?
Are there any industry best practices? I’m
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It depends on the context. Let's say you're assessing the fair market value of a vacant lot on which you can build an apartment building. When you value the lot with a DCF your discount rate will be what you believe the market to be (i.e. what the market's required rate of return is for an apartment development project in that location). Ideally, you'd be able to find comparable projects to back-in to a discount rate. However, if you're not doing a valuation for a client and you're just doing it for yourself or something unofficial then you could use your own intuition and knowlege of the area and word of mouth to find out what a "market" discount rate is.
On the other hand, if you're assessing the lot as your own project or your company's own project then you use your own required rate of return. That required rate of return could be anything--1%, 100%, anything. It's an entirely subjective number.
Ultimately, the "market" discount rate is the population of IRRs required by bidders which are used to bid on the lot. The final "market" discount rate is the lowest discount rate that a seller can obtain given a population of bidders.
My understanding is that in practice, very few actually use a "discount rate" to come up with a present value for what they think the property is worth. Instead, you project the cash flows and use the listed price/whisper price as a means of coming up with an IRR and determining if that IRR is appropriate given the risk of the deal. Someone please correct me if I'm wrong.
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If you have a price of course that’s what you would do. If you don’t have a price—and you often won’t—then you would run scenarios with your own and what you think the market’s discount rate is and then try to reconcile to get to a number you feel comfortable offering that would also be competitive. It’s an art, not a science.
I very very rarely see brokers refuse to give a whisper price. The firm I’m with is one of the larger players in our space, and we never perform a DCF to arrive at a property value. With that said, if during due diligence we will discover large, near-term capital expenses that materially changes the narrative presented to us, then we will discount that capital expense and deduct that from our purchase price in a retrade. That’s only happened like 1 or 2 times in the last five years though. In that scenario, we typically use 8%-10%, and that seems to be fairly standard in the industry.
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