How to calculate a hurdle rate (or how not to)
02-06-2006
In contrast to what business schools have been teaching for decades, the hurdle rate is seldom used as an investment criterion when doing viability studies. This has been the experience of Rode & Associates’ team of property valuers and economists when collecting data for the national surveys analysed in its quarterly Rode’s Report.
Many property-investing professionals do not seem to be all that certain about hurdle rates, says Rode & Associates CEO Erwin Rode. He defines the hurdle rate as the total return required by potential investors to induce them to invest in property − that is, the income yield plus the expected capital appreciation. Synonyms for hurdle rate are the required total return or cost of capital (not to be confused with the cost of loan funds).
Rode says the hurdle rate is the correct discount rate to use for valuations and viability studies, because it represents the opportunity cost of not being invested in property. He regards it as a great pity that the hurdle rate is not more widely used because even when using capitalization as the primary valuation method, a measure of discounting – which requires a discount or hurdle rate - is still called for most of the time when valuing income-producing properties.
An old rule-of-thumb to calculate a hurdle rate is to add the leaseback escalation rate to the capitalization rate of a property. This method makes the following two assumptions: firstly, it assumes that the capitalization rate will remain constant (or at least change slowly) over the investment period and, secondly, that the leaseback escalation rate is a good proxy for the growth in future market rentals, and hence capital growth. The degree to which these assumptions hold will determine the reliability of the rule-of-thumb. However, in our experience the resultant answer is normally overstated somewhat. This could, inter alia, be the result of structural changes that are causing capitalization rates and escalation rates to decline, and the ageing of buildings (causing income streams to under-perform long-term escalation rates). Furthermore, previous research by Rode suggests that the escalation rate has not been a good predictor of market-rental growth in the past.
Another method commonly used to calculate a hurdle rate is to start with the long-bond rate − i.e. the so-called risk-free rate − and to add to this a risk premium. This method is flawed in two ways: firstly, the risk premium is not known from empirical evidence, and, secondly, long-bond yields are more volatile than capitalization rates (property values do not fluctuate with bond prices).
