What Is The Correct Discount Rate?

[Goat]

Regarding agents fees and void periods, I believe that these need to be included in the discount rate even though they don't apply to owner occupiers.

This is because the rents paid implicitly include these expenses, if you wanted to exclude them you would have to adjust the annual rental as well.

[grizzly bear]

Regarding agents fees and void periods, I believe that these need to be included in the discount rate even though they don't apply to owner occupiers.

This is because the rents paid implicitly include these expenses, if you wanted to exclude them you would have to adjust the annual rental as well.

Yes but the value of a house is what someone is prepared to pay, and so I am happy to buy once it becomes cheaper to buy rather than to rent.

I have to take into account:

- the rent I have to pay

- cost of mortgage

- maintenance costs, and stamp duty if I buy

- the amount I think prices will rise by the time I move out in 25 years time

- the alternative post tax return I could make on my money

- my preference for owning

Therefore a OO (with a decent deposit, and who wants to live there long term) should ALWAYS be prepared to pay more than a BTL investor as:

- they don't have to take voids and agents fees into account

- if they rent they have the 40% tax on interest income

So a BTL probably only makes sense at around an 8% discount factor but buying as an OO makes sense at 5%.

[Goat]

Most of us are familiar with the idea that one measure of the true value of a house is its annual rental value divided by an appropriate discount rate, such that a house generating £6,000 per annum is worth £120,000 if you apply a 5% discount rate and £60,000 with a 10% discount rate.

The only real problem is knowing what discount rate to apply.

Traditional rules of thumb have tended to imply discounts of 8% to 12% but can we do better than this?

As a rough guess I would say take a possible long term mortgage rate of say 5%, multiply by 3/2 to allow for agents fees, voids and maintenance, which gives you 7.5% and then add in a risk premium of perhaps 0.5% and you get a discount rate of 8%.

Other posters (of the Scottish trolling wind up merchant variety) will tell you that a 4% inflation proofed gross yield is brilliant.

So what is the approprate discount rate for property?

(P. S. Can posters confine this to the original question - I don't want dozens of pages arguing about the merits of the underlying method)

Edited June 3, 2009 by Young Goat

[grizzly bear]

So what is the approprate discount rate for property?

I agree with 5% as a long term average, although I don't agree with the 3/2 a bit high for voids/maintenance because if you are buying the voids/agents fees is not relevant. ie put another way, when I am deciding to buy or rent, I don't worry about the agents fees nor the cost to the landlord of the voids - I worry about the cost to me.

Maintenance is a cost if buying and as you say there is a risk premium of buying plus stamp duty costs so both these factors should increase the discount factor. But if I rent and my STR money is the the bank I have to pay 40% tax on the interest - making renting less attractive, thus reducing the discount factor.

So I would say 5% - and I would jump to buy my rental house at a rental yield at a 5% (or even a 4.5%) price.

[M21er]

Most of us are familiar with the idea that one measure of the true value of a house is its annual rental value divided by an appropriate discount rate, such that a house generating ?6,000 per annum is worth ?120,000 if you apply a 5% discount rate and ?60,000 with a 10% discount rate.

The only real problem is knowing what discount rate to apply.

Traditional rules of thumb have tended to imply discounts of 8% to 12% but can we do better than this?

As a rough guess I would say take a possible long term mortgage rate of say 5%, multiply by 3/2 to allow for agents fees, voids and maintenance, which gives you 7.5% and then add in a risk premium of perhaps 0.5% and you get a discount rate of 8%.

Other posters (of the Scottish trolling wind up merchant variety) will tell you that a 4% inflation proofed gross yield is brilliant.

So what is the approprate discount rate for property?

(P. S. Can posters confine this to the original question - I don't want dozens of pages arguing about the merits of the underlying method)

Hi YG,

Interesting question.

Personally, I don't feel that 0.5% is anywhere near enough of a risk premium. I would say you need to add 4% - 5% risk premium to cover the risks involved.

In addition, I wouldn't factor the maintenance / agent's fees / voids into the discount rate - I would have a clean discount rate based on risk free cost of capital plus the risk premium.

I would include estimates for the voids, agent's fees, maintenance etc into the cashflow which is then discounted by the clean discount rate.

You will have cyclical lifecycle costs of ownership as well eg Replacement of furniture, Replacement of bathrooms and kitchens etc which will need to be factored in.

Also, there is your time - owning an investment property even if it's managed is more time consuming than more passive savings / investments.

There is the worry of tenants not paying rent - not sure if that's covered by the risk premium!?

M21er

[lowrentyieldmakessense(honest!)]

Most of us are familiar with the idea that one measure of the true value of a house is its annual rental value divided by an appropriate discount rate, such that a house generating �6,000 per annum is worth �120,000 if you apply a 5% discount rate and �60,000 with a 10% discount rate.

The only real problem is knowing what discount rate to apply.

Traditional rules of thumb have tended to imply discounts of 8% to 12% but can we do better than this?

As a rough guess I would say take a possible long term mortgage rate of say 5%, multiply by 3/2 to allow for agents fees, voids and maintenance, which gives you 7.5% and then add in a risk premium of perhaps 0.5% and you get a discount rate of 8%.

Other posters (of the Scottish trolling wind up merchant variety) will tell you that a 4% inflation proofed gross yield is brilliant.

So what is the approprate discount rate for property?

(P. S. Can posters confine this to the original question - I don't want dozens of pages arguing about the merits of the underlying method)

these may have the information

http://www.ipd.com/OurProducts/Indices/tab...00/Default.aspx

the rate obviously varies depending on where we are in the property/business cycle

residential - i think 8-10% - but i think it has been as high as 15% and as low as 3%

commercial - keep it simple 10% - but i have seen 25% in the depths of the 90's recession and as low as 4% when idiots were buying property just because M&S were the tenants

[Goat]

Therefore a OO (with a decent deposit, and who wants to live there long term) should ALWAYS be prepared to pay more than a BTL investor as:

- they don't have to take voids and agents fees into account

- if they rent they have the 40% tax on interest income

So a BTL probably only makes sense at around an 8% discount factor but buying as an OO makes sense at 5%.

In which case investors would always loose out to OO's and would exit the market until rents rose so that the equilibrium between the discount factors would be restored.

[grizzly bear]

In which case investors would always loose out to OO's and would exit the market until rents rose so that the equilibrium between the discount factors would be restored.

True, but I think the problem is that the BTL investors have not been considering rental yield and have instead been focussing on capital gains, so they have been prepared to overpay, as a result, there is possibly too much rental property available and this is pushing rents down.

I think that especially for larger/forever houses, OO would always pay more than BTL investors, because these are the houses that people want to settle down in with a family, hence I am sticking to 5%. My friend moved to Canada and found that there were no family houses for rent at all in the neighbourhood where she wanted to live - I expect because the sums don't make sense for a potential landlord.

For smaller properties where there is less incentive to own it might be different, so the discount rate would be higher.

[Duplex]

Another way of looking at what may be a fair discount rate is by constructing an 'equated yield'. Take the yield on ten year UK Gilts (about 4%) and add a risk premium to account for sector risk. In the case of BTL the risk premium would have to account for factors like certainty of rental income; repairs/refurbishment, legislative risk, etc. My stab in the dark would be a risk premium of 3-5% for BTL depending on location and building type. That would suggest a discount rate of about 7-9% for Uk BTL.

[abharrisson]

Most of us are familiar with the idea that one measure of the true value of a house is its annual rental value divided by an appropriate discount rate, such that a house generating �6,000 per annum is worth �120,000 if you apply a 5% discount rate and �60,000 with a 10% discount rate.

The only real problem is knowing what discount rate to apply.

Traditional rules of thumb have tended to imply discounts of 8% to 12% but can we do better than this?

As a rough guess I would say take a possible long term mortgage rate of say 5%, multiply by 3/2 to allow for agents fees, voids and maintenance, which gives you 7.5% and then add in a risk premium of perhaps 0.5% and you get a discount rate of 8%.

Other posters (of the Scottish trolling wind up merchant variety) will tell you that a 4% inflation proofed gross yield is brilliant.

So what is the approprate discount rate for property?

(P. S. Can posters confine this to the original question - I don't want dozens of pages arguing about the merits of the underlying method)

If you want a nice little 2 bed terrace BTL then soemwhere around 7-12% yield is the right number... if you want a large family house then maybe 3% , if you want a farmhouse in the country perhaps 2%, if you want a decent flat in very central london then maybe 4% or 5% etc etc..... every property will have a corresponding rental value but it varies from property to property and street to street and city to city... there is no rule of thumb that will help you.

[abharrisson]

I alos forgot to add that using an "investment" methodology works where you are investing but as most people who buy are buying for a home then using an investment methodology is wrong.... you'll always I suspect end up judging the deal as non-favourable and therefore will remain renting.

[grizzly bear]

If you want a nice little 2 bed terrace BTL then soemwhere around 7-12% yield is the right number... if you want a large family house then maybe 3% , if you want a farmhouse in the country perhaps 2%, if you want a decent flat in very central london then maybe 4% or 5% etc etc..... every property will have a corresponding rental value but it varies from property to property and street to street and city to city... there is no rule of thumb that will help you.

Exactly the discount rate will depend on the incentive an OO has to buy the house and hence will be lower for large family house where OO would want to buy, customise and then live in for 25 years than 2 bed terraced house.

[economiccycle]

Most of us are familiar with the idea that one measure of the true value of a house is its annual rental value divided by an appropriate discount rate, such that a house generating �6,000 per annum is worth �120,000 if you apply a 5% discount rate and �60,000 with a 10% discount rate.

The only real problem is knowing what discount rate to apply.

Traditional rules of thumb have tended to imply discounts of 8% to 12% but can we do better than this?

As a rough guess I would say take a possible long term mortgage rate of say 5%, multiply by 3/2 to allow for agents fees, voids and maintenance, which gives you 7.5% and then add in a risk premium of perhaps 0.5% and you get a discount rate of 8%.

Other posters (of the Scottish trolling wind up merchant variety) will tell you that a 4% inflation proofed gross yield is brilliant.

So what is the approprate discount rate for property?

(P. S. Can posters confine this to the original question - I don't want dozens of pages arguing about the merits of the underlying method)

[economiccycle]

When you say “economic value†are you talking about something different to the “market Valueâ€

CAPM etc.

By that I mean when someone buys a UK gilt the market value is what they pay for the stock and the economic value is the present value of the interest and capital payments.

Where “strong market efficiency exists†and people price for risk correctly the market value and the economic value are the same.

So if the risk free return is just under 4% and the average share is expected to produce 9.0% over the long term then the equity risk premium is 5.0%.

My guestimate of the long term return of an average share is dividend yield 4.5%+ inflation 2.0% plus GDP growth 2.5%.

So the question is how risky is holding a property compared to holding an average share?

I would say looking at equity and price movements buying a property is the same or slightly less risky when holding a share. I am aware recently holding either would of been very bad.

So I would guestimate 9.0% as a discount rate for houses or slightly less. Has anyone actually done any work on this?

I would off course build in an “expected†increase or fall of rental income i.e. discount at 9.0% but expect rent to increase at the level of salaries.

[grizzly bear]

When you say “economic value†are you talking about something different to the “market Valueâ€

CAPM etc.

By that I mean when someone buys a UK gilt the market value is what they pay for the stock and the economic value is the present value of the interest and capital payments.

Where “strong market efficiency exists†and people price for risk correctly the market value and the economic value are the same.

So if the risk free return is just under 4% and the average share is expected to produce 9.0% over the long term then the equity risk premium is 5.0%.

My guestimate of the long term return of an average share is dividend yield 4.5%+ inflation 2.0% plus GDP growth 2.5%.

So the question is how risky is holding a property compared to holding an average share?

I would say looking at equity and price movements buying a property is the same or slightly less risky when holding a share. I am aware recently holding either would of been very bad.

So I would guestimate 9.0% as a discount rate for houses or slightly less. Has anyone actually done any work on this?

I would off course build in an “expected†increase or fall of rental income i.e. discount at 9.0% but expect rent to increase at the level of salaries.

Re: inflation/GDP this is already included in the risk free return.

On the sort of housing I am renting it is totally delusional to say 9% is right discount rate. I am renting a 5 bedroom detached house. The 9% on my rent wouldn't even buy a small terrace in this area.

Maybe its my rent that is wrong and I should be paying 3 times as much???? But the house was empty for 2 months before we moved in so I can only assume he couldn't have got more.

As I said, at 5% I'd buy it (my rental house) tomorrow, we turned it down at 3.4% (we asked if we could buy it and that was the price the landlord came back with).

[tomwatkins]

Most of us are familiar with the idea that one measure of the true value of a house is its annual rental value divided by an appropriate discount rate, such that a house generating �6,000 per annum is worth �120,000 if you apply a 5% discount rate and �60,000 with a 10% discount rate.

The only real problem is knowing what discount rate to apply.

Traditional rules of thumb have tended to imply discounts of 8% to 12% but can we do better than this?

As a rough guess I would say take a possible long term mortgage rate of say 5%, multiply by 3/2 to allow for agents fees, voids and maintenance, which gives you 7.5% and then add in a risk premium of perhaps 0.5% and you get a discount rate of 8%.

Other posters (of the Scottish trolling wind up merchant variety) will tell you that a 4% inflation proofed gross yield is brilliant.

So what is the approprate discount rate for property?

(P. S. Can posters confine this to the original question - I don't want dozens of pages arguing about the merits of the underlying method)

When you say "most of us" I think you are mistaken. It's why yields are a mystery to most people and why BTL's amatures are in trouble. I know, because I speak to a lot of them-they equate high rents with high capital values, when in reality the reverse is true.

[economiccycle]

Re: inflation/GDP this is already included in the risk free return.

On the sort of housing I am renting it is totally delusional to say 9% is right discount rate. I am renting a 5 bedroom detached house. The 9% on my rent wouldn't even buy a small terrace in this area.

Maybe its my rent that is wrong and I should be paying 3 times as much???? But the house was empty for 2 months before we moved in so I can only assume he couldn't have got more.

As I said, at 5% I'd buy it (my rental house) tomorrow, we turned it down at 3.4% (we asked if we could buy it and that was the price the landlord came back with).

Hi Grizzly I am not saying what I think you think I am saying.

http://en.wikipedia.org/wiki/Capital_asset_pricing_model

As I am new to this forum it may be that the good folks on House price crash use the term discount rate differently to how I would use it.

I am saying when you buy a gilt the present value of the interest plus capital payments are discounted at the “risk free rateâ€. Rf just munder 4.0% at the moment

When you buy a share the present value of the dividend payments discounted at E(Ri) will be the economic value of the share. For an average share I guestimate 9.0%

I think that E(Ri) for a house would be 9.0% as I say it is a guestiamte as its a bit of an art form not a pure science.

[grizzly bear]

Hi Grizzly I am not saying what I think you think I am saying.

http://en.wikipedia.org/wiki/Capital_asset_pricing_model

As I am new to this forum it may be that the good folks on House price crash use the term discount rate differently to how I would use it.

I am saying when you buy a gilt the present value of the interest plus capital payments are discounted at the “risk free rateâ€. Rf just munder 4.0% at the moment

When you buy a share the present value of the dividend payments discounted at E(Ri) will be the economic value of the share. For an average share I guestimate 9.0%

I think that E(Ri) for a house would be 9.0% as I say it is a guestiamte as its a bit of an art form not a pure science.

I think in the context of this email the OP was working out how to value a house - based on yield ie if you take the rental yield whats the value?

But its not that straightforward MY choice therefore as a potential buyer (assume I have the money in the bank to buy the house) whether to buy or rent.

If I rent I generate bank interest on my deposit in the bank (but get taxed on this) but I have to pay rent. Unfortunately I have to pay 40% of my interest to HMRC AND my desposit gets eroded by inflation.

If I buy I neither pay rent nor receive interest - further assuming I buy at the right price I assume that my investment goes up inline with inflation.

Assume that 5% is the long term fixed rate; say my money in the bank can attract 5% over the long term, and if I borrowed lets assume thats the interest rate - well because of tax I only get 3% of that towards my rent.

So I make the following comments:

a) the appropriate discount rate is lower for cash buyers

the discount rate depends on where you buy in the cycle - buy at the bottom no risk of capital value falling so this lowers the discount rate, which should be higher if there is a risk prices can fall

c) as stated earlier discount rate depends on whether its the sort of house an OO would want to own (rather than rent - will be lower for bigger houses)

So answer to OP - there is no correct blanket discount rate.

[BandWagon]

Most of the posts on this subject have been close, but technically incorrect.

They've used either nominal interest rates or bond yields as the basis for valuation, but this doesn't apply to a long-term asset like property.

Rents are a component of the inflation index, and so the value of a house is a function of the real rate of interest, not the nominal rate.

So to get the risk free rate, have a look at the yields on index-linked gilts (ie gilts that have their coupon indexed to inflation)

The yield historically has been about 4%, and the risk premium for residential property has been about 3%, plus about another 1% for maintenance etc, and you have an 8% yield, which is about the long-term average.

This explains it well...

http://www.bankofengland.co.uk/publication...in/qb040102.pdf