A reasonable place to start deciding on the discount rate is by using the rate equal to the return the investors expect from the investment. For example, Investment A is acquired in a Value-Add Fund and is estimated to achieve a 15% gross IRR. For simplicity, let’s assume the FV of that investment is $10,000,000 in one year. To determine the PV of that amount, a good estimate would be to use the 15% discount rate which would equate to a PV of $8,695,652. Said another way, if you acquired the Investment A for $8,695,652 and sold it one year later for $10,000,000 then you would have achieved a 15% gross IRR.
A common mistake is to use a discount rate that is too low. In the example above, if you use a lower discount rate of 10%, then you would have been willing to acquire Investment A for $9,090,909 or $395,257 more than if you had used the 15% discount rate.
As mentioned above, this allows you to get a starting point for finding the appropriate discount rate. You will also need to consider the geography, property type, class of building, tenant risk, political risk, building specific risk, etc. before deciding on the rate you should use.
Discounted Cash Flow Model (DCF) Summary
DCF Valuations are used everyday in private equity real estate. Funds value their investments each quarter using DCF models. Buyers use the present value calculation to determine the acquisition price of potential investments. In order to conduct a DCF analysis, you must make assumptions about future cash flows and model those projections in a financial real estate model.
You must also determine an appropriate discount rate for the DCF valuation model, which will vary depending on the investment attributes and return expectations.
