When calculating the cost of equity, the common practice is to rely on a formula that includes the risk-free rate, beta, and the equity market premium. In some cases, however, the standard approach might not fully capture the unique risks of a specific company. That’s where a specific risk premium comes in. This article will guide you through how to adjust the cost of equity using a specific risk premium, especially when dealing with REITs and real estate assets.

In a previous article on cost of equity calculation, we discussed adding a specific risk premium to reflect additional risks not captured by the traditional beta. This adjustment is necessary if you think that beta, whether calculated from historical data or estimated using a sector average, doesn’t fully reflect the company’s risk profile. Perhaps the company differs from the typical firm in its sector, or current market conditions have changed dramatically. In this article, we’ll explore two methods for calculating a specific premium when using the REIT industry beta: one to adjust for differences across real estate sectors and the other to account for the quality of assets held by a company.

Understanding the Need for a Specific Premium

The beta used in the cost of equity calculation is meant to capture the systematic risk of a company. Systematic risk refers to the overall market risk that affects all companies, such as economic recessions or changes in interest rates. This type of risk is inherent to the entire market and cannot be diversified away, meaning that all companies are exposed to it to some degree. The beta reflects if the analyzed company is more or less exposed to this risk. However, beta might not always reflect all the risks of a specific company. The need for an adjustment, and the type of adjustment, depends on the methodology used for calculating beta. The logic we should use is: does the beta we used reflects the current risk of the company?

For instance, if we used the unlevered average beta of the REIT industry in our calculation of an office REIT, we need to consider that the REIT industry beta represents an average of all publicly traded REITs. These REITs operate across sectors like retail, office, industrial, data centers, and residential. Each of these sectors has different risk levels, and some companies within these sectors have unique characteristics that make them either riskier or less risky than the average. To better capture the risk of an office REIT, we may need to adjust the cost of equity to reflect the specific risk of the office sector compared to the overall average.

Adjusting for Real Estate Sector Differences

The REIT industry beta is calculated by averaging all publicly traded REITs, which represent a mix of sectors such as industrial, office, retail, data centers, and residential. Each of these sectors has its own risk profile, and as such, some are more volatile than others. To adjust the cost of equity, we suggest using the cap rate of different sectors as a measure of their relative risk.

Cap rates (or capitalization rates) are a common valuation metric in real estate, representing the expected rate of return on a property. Higher cap rates generally indicate higher risk, as investors demand a higher return to compensate for additional uncertainty. Thus, cap rates can serve as a useful proxy for adjusting the cost of equity by sector.

For example, let’s consider the data as of 2024 from sources like CBRE and JLL. The average cap rate across all sectors in a broad REIT index (such as the one used by the VNQ ETF) is approximately 6%. However, individual sectors can deviate significantly from this average:

  • Retail and office sectors typically trade at cap rates above 6%.
  • Residential and industrial sectors, on the other hand, tend to have cap rates below the average.

To make adjustments, we first calculate the difference between the average cap rate and the cap rate of the relevant sector. To convert this cap rate adjustment into an equity risk premium, we use a multiplier of approximately 1.3, which reflects the transmission from cap rate (equivalent to the weighted average cost of capital, or WACC) to cost of equity for non-tax-paying entities like REITs.

For example:

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  • Residential REITs: The cap rate for residential properties is typically lower than the average. If the cap rate is 5%, the difference from the average (6%) is –1%. By multiplying this by 1.3, we arrive at a specific premium adjustment of –0.97%. This means that the cost of equity for a residential REIT should be adjusted downward by 0.99% compared to what we’d calculate using the industry beta.
  • Office REITs: Conversely, the office sector may have a cap rate of 6.5%, which is 0.5% above the average. Multiplying this difference by 1.3 gives us an adjustment of +0.48%. Therefore, the cost of equity for an office REIT should be increased by 0.48%.

Adjusting for Quality of Assets

The next adjustment involves the quality of the assets held by the REIT. Not all properties are created equal—class A, B, and C properties come with different levels of risk. Class A assets are considered the highest quality, with stable, high-paying tenants and prime locations, while class B and C assets are riskier.

Investors typically accept lower returns for class A assets because of their quality and reliability, whereas class B and C assets require higher cap rates to compensate for increased risk. This difference can also be used to adjust the cost of equity.

For instance, the cap rate difference between class A and class B assets has historically been around 1% for assets in various sectors. Therefore, if we have calculated a beta using a sample of companies holding mostly class A assets, but the company we are analyzing owns mostly class B assets, we should add a specific premium of 1% multiplied by 1.3, resulting in an adjustment of +1.3% to the cost of equity.

If we consider class C assets, which have a cap rate premium of 1.5% to 2% over class A assets, we need to make a larger adjustment. For a company owning predominantly class C assets, the adjustment would be between +2% and +2.6% (using the same multiplier of 1.3).

How to Determine Asset Class

One of the challenges of applying this method is determining the class of assets a company owns. Unfortunately, companies do not always explicitly disclose whether their properties are class A, B, or C. However, a good indicator of asset class is the rent level compared to the market average:

  • Class A properties command higher rents relative to the market.
  • Class B properties have average rents.
  • Class C properties tend to have below-average rents.

To determine the asset quality of a company, you can calculate the average rent of its properties in each market and compare it to local market averages. This helps deduce the asset class and determine the appropriate risk premium to add to the cost of equity.

Conclusion

Calculating the cost of equity for a company requires a detailed approach. By adding a specific risk premium, you can better account for unique risks related to sector differences and asset quality that are not captured by traditional beta calculations. This results in a more accurate representation of the cost of equity, ensuring that investors are adequately compensated for the risks they undertake.

The next time you’re evaluating a REIT, consider whether an adjustment for specific risk is warranted. It may make the difference between a realistic assessment of expected returns and an under- or overestimation that could affect your investment decision.

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. For more details, please refer to our full disclaimer.