Flexibility and Real Estate Valuation under Uncertainty

2Economics of the Discounted Cash Flow Valuation Model: Understanding the Discount Rate is Critical

LEARNING OBJECTIVES

• Understand the opportunity cost of capital (OCC) and its basis for the discount rate;
• Understand the differences between discount rate, OCC, and internal rate of return (IRR);
• Learn the concept of net present value (NPV) and how it differs in concept and use from the IRR;
• Understand the relationship between discount rate, growth rate, and yield;
• Understand the relationship between discount rate and risk.

OUTLINE OF THE CHAPTER

1. 2.1 Choice of Discount Rate
2. 2.2 Differences between Discount Rate, Opportunity Cost of Capital, and Internal Rate of Return
3. 2.3 Net Present Value
4. 2.4 Relationship between Discount Rate, Growth Rate, and Income Yield
5. 2.5 Relationship between Discount Rate and Risk
6. 2.6 Conclusion

This chapter explains the concepts needed for a good economic valuation of a real estate property or development, and distinguishes between the various terms used in this process. You may think of this chapter as the conceptual counterpart to the discussion of the mechanics of discounted cash flow (DCF) in the preceding chapter. It is our opportunity to make sure that we are all on the same page regarding the basic concepts and meanings associated with the valuation of real estate and use of the DCF model.

2.1 Choice of Discount Rate

Mechanically, the discount rate we use in the DCF valuation model simply converts future cash flow amounts ...