More on Discount Rates

The cap rate discussed in the previous post on home valuation are just industry speak for the more generic term discount rate. This is also known as the hurdle rate, required return, and other terms.  This rate is critical for valuation. Riskier investments demand higher returns (higher discount rates).  Safe investments are more expensive, for a given cash return, than riskier investments.

For example, as of this writing, a Treasury note which pays a coupon (annual interest payment) of $40.00 per year plus an additional $1,000 on the due date (maturity) of August 15^th, 2018 costs $1,171.70.  A GE Capital (rated AA) bond, which pays the same coupon of $40.00, and the same $1,000 on the same due date costs $1,040.00.  These bonds are otherwise identical: they pay the same coupon and the same principal (face value) on the same exact day, yet the Treasury note costs more than 12.5% more than the corporate bond. 

The same can be said for all other investments.  For a given cash payment, the riskier it is, the cheaper it should be.  And this is where your judgment comes into play.  If you think a local cap rate is too high and leads to too low a bid price for a home, you can adjust it lower, which would raise the bid value for the home.  Just don’t go overboard.  You want to make a wise investment, even if you plan on staying in the home forever.  Remember, the return to you is the rental rates you would have otherwise paid.  You should want to save those rental payments for the least amount of money.  In other words, pay less.