What discount rate should you use for your occupier decision analysis?

HOUSTON - Jan. 4, 2023 - PRLog -- All commercial real estate occupiers should carefully consider the discount rate which is utilized in comparing their occupancy options, particularly when comparing leasing to owning, or negotiating a sale/leaseback and weighing that against continuing to own.  Your commercial real estate advisor/broker will likely begin with some kind of assumed discount rate to provide some numbers for your review, but the appropriate discount rate should ultimately be determined by the decision maker and his or her finance department.

When choosing a discount rate for occupier analysis, one should consider the risk associated with the cash flows, the type of company, the company's industry and the occupier's cost of capital.  Corporate and non-corporate (individuals, partnerships, or sole proprietorships) have different considerations in selecting a discount rate.

Non-corporate occupiers typically use their opportunity cost to evaluate their occupancy options.  A non-corporate user considers the alternative uses for the funds and the returns on those alternative uses.  An obvious alternative is to invest it in their business.

Corporate entities typically use their weighted average cost of capital (WACC), which can also be called the "hurdle" or "threshold" rate, or they may choose to use their borrowing rate (for lower-risk cash flows) and their cost of equity capital (for higher risk cash flows).

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital, in which each category of capital is proportionately weighted by the percentage of debt and percentage of equity. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.  Unfortunately, it is not a simple calculation, and there are various approaches to calculating it.  For example, one could use the "historic" approach, which uses the existing debt-to-equity ratio and existing after-tax cost of capital, or one could use the "marginal" approach, which uses the existing debt-to-equity ratio and the projected after-tax cost of new capital...

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