Stupid question: Why discount development/acquisition costs > opp. cost of capital?
One thing I see over and over again in CRE textbooks but never quite understood is the discounting of development or acquisition costs for a project.
So for an extremely simple example:
Let's say project X costs $100 for 3 years, and has revenues of $100 for 7 years starting in year 3. And let's say the US 10-year treasuries are yielding 3%.
I constantly see examples where the developer will then discount his costs at 4%. Why the +1%??
I've never fully understood this.
Keep in mind the answer can't be just that the uncertainty of the project discounts the cashflow. You have basically a decision tree framework with the positive cash flows resulting from a 100% dependency on the negative cash flows. So you can never have the positive cashflows without the negative cash flows (if you don't build it, no one is going to pay you occupy it).
So why discount your outlays any more than the time value of money you will earn on them in short-term, liquid investments (i.e. the treasuries)?
I may be wrong, but it could just be a margin of safety. the higher discount rate that you apply, the more risk you are accounting for in your dcf
If you think about it, though, discounting your cash outlays is not providing a margin of safety. This is because these are outlays, not income.
The additional % compared to a 10 year treasury is attributable to the risk premium associated for this deal. No one would argue a 10 year “risk free” T note has the same risk as a CRE investment, esp. a development opportunity. Do not think about it as a margin of safety; think about it as the riskiness of the investment, which in CRE there is a ton of development & leasup risk. 4% is extremely low in my opinion; I feel for development opportunities the discount rate should be more around 12%.
I don't mean to be rude, but so far the question is being misunderstood.
Let me explain.
If you have to pay for your kid's college expenses in 10 years, how do you discount those expenses? You would discount them by the opportunity cost of capital. So what that means is that if you can sit comfortably with the idea that you can comfortably be earning 5% in the market over those 10 years, discount that outlay by 1/(1+.05)^10. Off the top of my head, that outlay probably comes to about 6-7 grand.
So why would you discount that even more!!!! That makes no sense, yet I see textbooks sometimes do it, sometimes not (granted, I have a total of 2 textbooks on CRE finance, Linneman & Geltner).
So as you can see, this discount rate has nothing to do with return relative to risk.
Both above answers are wrong.
Generally speaking, one discounts all cash flows of a given project at the same discount rate. You don't discount the outlays at a different rate from the income.
It's the uncertainty of the income that will dictate the risk premium and cost of capital. So let's use an example: let's say a developer has a project that will cost $1MM of equity and the cost of the equity is 20% (given the risk of the project). If he calls the $1MM all at one, the clock starts ticking on the whole amount from day one. If he can delay part of the spending by, say, drawing $500K today and $500K next year, he's saved himself from having to earn a 20% return during the first year on the $500K portion he delayed.
Does that make sense?
re-ib-ny, you are way more knowledgeable than I and an asset to these forums, but I'm not sure if you're entirely correct here.
I do see your logic. You're saying Risk Premium = Cost of Capital = Discount Rate. But discounting your future cash OUTflows means you should put away LESS today to spend in the future. The reason to discount future cash outflows would be the time value of money... but what else?
I'm also not sure if the discount rates should necessarily be the same. Before going into my own logic for that, I know for a fact that Linneman explicitly says in his textbook that they should NOT be the same (I'm looking at his passage right now).
I think the problem may be we're thinking of two similar, but different, concepts. Or I'm just not understanding you and/or Linneman.
Econ, some valuation professionals certainly take your view. Here is an interesting chapter from Aswath Damodaran on various complications and controversies in project valuation, particularly as it relates to risk and discount rates: http://people.stern.nyu.edu/adamodar/pdfiles/valrisk/ch5.pdf
On pages 8 and 9 he goes into depth on the debate over using differing discount rates in a multi-period model and also his view on how to treat positive versus negative cash flows. He argues that using a different discount rate for outflows is internally inconsistent. I do, however, understand your point, and see how you can defend that position from a theoretical perspective.
The practical reality, however, is that real estate investors generally have an absolute return hurdle. The level of implied risk is going to dictate what kind of an investor will buy / invest (core fund / REIT, value-add fund, opp fund, etc.). The expectation is that the cash flows on an aggregate basis will achieve that absolute IRR hurdle. Hence, I think to understand how investors will value a deal, I personally think you get more insightful results by applying a consistent discount rate.
This kind of confusion is why I am not a fan of some classes/textbooks. Sometimes these models get overcomplicated.
Qui quia et minima quo vitae labore. Neque id ut ut dolores dicta voluptas totam eos. Temporibus dicta natus accusantium veniam aspernatur rerum commodi quisquam. Est magnam architecto alias odit. Voluptate rem fuga quam omnis. Ex aperiam accusantium nihil qui nisi.
Dolorum totam est nostrum dolore quis eos officiis voluptatem. Dolorem a consequuntur aut ipsam voluptatem.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...