The discount rate for income properties

Abstract

Due to the lack of liquid and transparent markets it is extremely difficult to estimate betas for income property returns. Because of these difficulties, the CAPM is discarded by practitioners when valuing income properties. Instead, free cash flows are often discounted with rates derived from Gross Yields. However, Gross Yields only apply to income streams and other cash flows closely correlated with income whereas different discount rates must be applied to other cash flows such as expenses and investments. It is remarkable that this obvious anomaly has not been previously pointed out in the literature on real estate valuation. The common practice of discounting free cash flows with Gross Yields results in an overvaluation bias. Through a simple example it is demonstrated that the bias is more pronounced for larger gross yields, and the more important are the less risky cash flow streams in relation to the income correlated ones.