Risk Adjusted Discount RateThis rate represents in essence the required periodic return by the investor for committing funds to the particular property. It is typically calculated as the sum of the risk free rate and a risk premium. This risk premium varies depending on two factors: the magnitude of the risk of the property investment as perceived by the investor and the investor’s risk aversion. For the same risk level, the risk premium will be higher the higher the investor’s risk aversion is. Real estate has several sources of risk that in turn affect the discount rate that a property investor may use. These sources are discussed extensively in this article. Risk-adjusted discount rates vary across property types as historically they have shown different risk profiles. Typically, the risk of an investment is measured as the volatility of historical returns. US investors often look at the historical volatility of investment returns for different property types (apartment, retail, office and industrial) as measured by respective indices published by the National Council of Real Estate Investment Fiduciaries (NREIF). These indices are based on a large database of investment-grade properties owned by major institutional investors in the United States. An issue that has been identified in the literature in terms of comparing the volatility of these indices and resultant risk measures with the volatility of other investment vehicles, such as stocks and bonds, which are traded daily, has to do with the fact that most of the values taken into account in calculating the capital return component of the NCREIF index from period to period are based on valuations as opposed to transactions. This creates an appraisal smoothing bias, which results in lower risk estimates compared to investment vehicles that are traded daily. However, this bias should be more or less uniformly affecting all NCREIF indices representing the different property types and, therefore, we can still get a good idea in terms of which property types are more risky and less risky by comparing their historical volatility.
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