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Required rate of return

The required rate of return is the minimum return an investor must expect in order to be willing to put money into a property rather than another investment alternative. It is the price of risk: the more uncertain the cash flow, the higher the return the investor demands for taking it on. The required return is the starting point for all valuation of commercial property, because it determines how much future rental income is worth today.

The required return is built up in layers. The bottom layer is a risk-free rate, normally the yield on a long Norwegian government bond, which reflects what you get without risk. On top of this comes a risk premium for property as an asset class, and then add-ons for the individual asset: location, the standard of the building, tenant financial strength, remaining lease term (WAULT) and relocation risk. A new building at Aker Brygge with a 15-year government lease has a low required return; an older office building in a smaller town with a short lease term has a high one.

The required rate of return is closely linked to yield and the capitalisation rate. In practice the terms are used interchangeably, but the required return is what the investor wants, while the yield is what the market actually prices. In a discounted cash flow the required return is the discount rate that converts future cash flows into a present value, and it is closely related to the internal rate of return (IRR), which measures the actual return a purchase delivers. For a debt-financed purchase, you distinguish between the required return on total capital and the higher required return on equity, which rises with the loan-to-value ratio.

When interest rates rise, the required rate of return rises, and then values fall even if rent is unchanged. This is the main mechanism behind the fall in values in Norwegian commercial property during periods of rising interest rates: an increase in the required return from 4.5% to 5.5% can on its own reduce the value of a building by more than 15%. That is why investors follow Norges Bank's interest rate path just as closely as they follow the rental market.

In Placepoint you can bring together market value, NOI and lease details when you assess the required rate of return a property should be priced at.

From Placepoint's dictionary: Required rate of return

More information: Eiendom Norge: Market Reports, Norges Bank: Interest rates, Store norske leksikon: avkastning

English: Required rate of return (hurdle rate).

Common questions we come across

What is a required rate of return?

The required rate of return is the minimum return an investor must expect in order to put money into a property rather than an alternative. It is the price of risk and the starting point for valuing commercial property: higher risk gives a higher required return.

What is the difference between the required rate of return and yield?

The required rate of return is what the investor wants to achieve, while the yield is what the market actually prices the property at. In practice the two are close to each other, and in a discounted cash flow the required return is used as the discount rate.

How is the required rate of return set?

It is built up in layers: a risk-free rate (a long government bond), a risk premium for property, and add-ons for location, standard, tenant financial strength and remaining lease term (WAULT). Debt financing gives a higher required return on equity than on total capital.

Why do property values fall when interest rates rise?

Because the required rate of return follows interest rates. If the required return rises, future rental income must be discounted more heavily, and the value falls even if rent is unchanged. An increase of one percentage point in the required return can reduce the value by well over 10%.