One of the major methods to value companies or REITs is DCF (discounted cash flow), where we forecast the cash flows and calculate their present value by discounting them to today. The discount rate used, when we forecast the cash flow to the shareholders of the company, is the cost of equity. The cost of equity represents the rate of return that equity investors expect for their investment in the REIT.
Understanding how to properly calculate this rate helps investors make informed decisions, and it’s also an essential component for financial analysts who wish to provide reliable assessments of value. This article breaks down the concept, explaining the cost of equity calculation, its components, and the methodologies used to estimate it.
Cost of Equity vs. WACC
Before diving into how to calculate the cost of equity, it is important to clarify that cost of equity and weighted average cost of capital (WACC) are not the same. Though they both relate to valuing a company’s returns, the cost of equity is used to determine the present value of the cash flows available to equity holders (after interest payments), while WACC is used to value the operating cash flows after taxes.
In real estate, WACC is roughly equivalent to the capitalization rate (cap rate), which measures the overall expected return on an asset. The cap rate is often used in real estate to assess property value, while the cost of equity is specifically the return expected by the owners of the equity in the asset. In essence, WACC incorporates both debt and equity components, while the cost of equity focuses solely on the returns expected by the equity stakeholders.
Components of Cost of Equity
The basic calculation of the cost of equity can be expressed through a simple formula:
Cost of Equity = Risk-Free Rate + Risk Premium
Let’s break this formula down.
1. Risk-Free Rate
The risk-free rate represents the return on an investment with zero risk. For most calculations, the risk-free rate is derived from government bonds with long durations, ideally equivalent to the time horizon of the investment being considered. Since equity typically represents a long-term investment, and the duration of equity cashflows are around 15 years, analysts often use the yield on 15-year government bonds as a proxy for the risk-free rate.
However, the type of cash flows we expect matters here. If we’re forecasting real cash flows (cash flows without inflation), then we should use a real risk-free rate, such as the yield on inflation-indexed government bonds. On the other hand, if our forecasted cash flows are nominal (including inflation), we should apply the nominal risk-free rate.
2. Risk Premium
The risk premium is what makes investing in a REIT more attractive than putting money into a risk-free government bond. It accounts for the additional risk that equity investors take on by investing in a REIT. This premium is influenced by the risk profile of the company relative to the overall market. We calculate it by estimating the Beta, and multiplying it by the risk premium of the stock market. Beta represents the volatility (risk) of the company compared to that of the overall market. A beta greater than 1 indicates that the company is more volatile than the market, while a beta less than 1 suggests lower volatility.
For example, if a REIT has a beta of 1.2 and the market risk premium is estimated at 5%, the risk premium for that REIT would be 1.2 * 5% = 6%.
Adjusting Beta
The beta used in calculations can come from different sources. We can use the historic beta of the analyzed company if it has a sufficient trading history and we think that past performance is indicative of the future.
Another option, preffered by me, is to use the beta of the sector or similar companies. When using a sector beta, it should be adjusted for the leverage of the specific company.
Adjusting beta for leverage accounts for the effect of debt on a company’s risk profile. Typically, an unlevered beta (which excludes the impact of debt) is calculated first, and then adjusted to reflect the company’s actual debt levels—resulting in a levered beta.
Following is the equation of levered and unlevered Beta:
Levered Beta = Unlevered Beta * [ 1 + ( 1 – Tax Rate ) * Debt / Equity ]
This adjustment can sometimes create a circular calculation. The value of equity is affected by the cost of equity, which in turn depends on the value of the beta that includes leverage. In practice, this often means adjusting the beta iteratively until it converges to a consistent result.
Following are the historical unlevered Beta of REITs, as calculated by Prof. Damodaran from NYU:
For REITs, I feel comfortable to use an unlevered Beta of around 0.5, since it’s roughly the average and median of the U.S., European and Global REITs over the last 10 years.
Market Risk Premium
The market risk premium can be calculated in a few different ways:
- It can be based on the current premium (an estimate of the current required return over the risk-free rate). We can find the current premium on the website of Prof. Damodaran.
- Alternatively, it can be based on a long-term historic average. If we believe in regression toward the mean, this approach can provide a stable estimate that smooths out short-term volatility. I prefer this approach and for U.S. companies, I use a premium of 5.3%, the average of the last 10 years.
Considering Additional Specific Risk Premium
Sometimes, using just the beta and market risk premium doesn’t adequately reflect all of the risks associated with a company. In these cases, an additional specific risk premium may be added or subtracted. We should consider adding a specific risk premium if we believe the Beta we used doesn’t reflect the risk of the analyzed REIT well.
For example, if we calculated the beta using five years of historical data but believe that the company’s risk profile has recently changed, the historic beta may no longer reflect the current reality. Similarly, if we compared the analyzed company to a set of peers but believe that it is inherently less risky than its peers, an additional adjustment might be justified.
Adding or subtracting a specific risk premium helps account for company-specific nuances that the standard beta calculation may not fully capture. Since I like to use the historic average Beta of REITs, it should be adjusted for changes in the risk of real estate sectors and to the asset quality of the analyzed REIT. Another adjustment that needs to be considered is the amount of development compared to an average REIT.
Example: Cost of Equity Calculation for a Hypothetical REIT
Let’s walk through a quick example to pull all these pieces together.
Imagine we are calculating the cost of equity for REIT X, which owns class A office buildings. Following is the calculation:
- Risk-Free Rate: 4.56% (based on the current nominal 15-year government bond yield, since the increased the NOI in line with inflation).
- Beta: 1.12 (adjusted for leverage, based on an unlevered industry beta of 0.56 and adjusted for REIT X’s specific debt level).
- Market Risk Premium: 5.33% (based on a long-term historical average).
- Specific Risk Premium: 0.47% (added to account for the higher risk of the office sector).
Thus, the cost of equity for REIT X is 11%. This means that the expected rate of return that equity investors require for investing in REIT X is 11%, which we would use to discount the cash flows to equity holders of the REIT.
Changing Leverage and Time-Varying Costs of Equity
In some cases, the capital structure of the REIT may change over time, which directly impacts its cost of equity. When this is expected, we should calculate the cost of equity for each year separately to accurately reflect these shifts in leverage.
Similarly, a specific risk premium might change over time as the company matures, faces different risks, or makes strategic shifts. For instance, a REIT investing in a relatively new property sector may initially carry a higher specific risk premium, which might decrease once the sector becomes more established and less risky
Summary
- Cost of Equity Definition: The cost of equity is the return that equity investors expect for their investment in the REIT. It is used to discount future cash flows to determine the fair value of equity.
- Cost of Equity vs. WACC: Cost of equity focuses on the return expected by equity holders, while WACC (weighted average cost of capital) considers both equity and debt components. In real estate, WACC is roughly equivalent to the capitalization rate (cap rate).
- Components of Cost of Equity:
- Risk-Free Rate: Typically derived from long-term government bonds, ideally matching the investment horizon. Real rates are used for real cash flows, while nominal rates are used for nominal cash flows.
- Risk Premium: Calculated as beta multiplied by the market risk premium. Beta measures the company’s risk relative to the market.
- Beta Calculation: Beta can be calculated using the historical beta of the company or the sector. Adjustments for leverage are required when using sector betas to make them applicable to the specific company.
- Market Risk Premium: This can be estimated using current premiums or long-term historical averages. A stable historical average can provide a more reliable estimate.
- Specific Risk Premium: Sometimes, additional specific risk premiums are added to better capture company-specific risks not reflected in beta.
- Changing Leverage: If a REIT’s leverage or specific risk factors are expected to change over time, the cost of equity should be adjusted yearly to reflect these changes.
Disclaimer: The information provided in this post is for informational purposes only and reflects my personal opinions. It should not be considered as professional financial, legal, or investment advice. Please consult with a professional before making any investment decisions. I am not responsible for any actions taken based on this information. The full disclaimer can be found here.