What you need to know before investing in real estate (factors to consider in the capitalization method)

As discussed in the previous post, inflation will directly affect our decision-making when considering a real estate investment..

It was explained, and it's crucial to remember, that any interest rate or profitability measure originating from the market, such as: the yield on government debt, the well-known APR or cost of a loan, or even stock returns, are all nominal values and therefore already include inflation.

Example: Risk Premium Calculation

We will continue with the final example from the previous post, which examined the risk premium in the capitalization method, calculated the real interest rate of Spanish Debt, and finally determined the nominal rate of an investment.

To finally calculate in this post the CALCULATION OF THE RISK DIFFERENTIAL GIVEN THE REQUIRED RETURN BY AN INVESTOR.

There is a relationship between these values:

(1 + nominal interest) = (1 + real interest + risk premium) x (1 + inflation)

In practice, the yield on government debt is taken as the real interest rate, because it is assumed to be a risk-free investment, or rather, one with minimal risk.

To help understand everything mentioned, an example will be provided:

Let's imagine that the average annual yield of the 5-year government debt in the secondary market is 5%.

This is a NOMINAL value because it comes from the market, and therefore, to calculate the real return with risk, assuming an inflation of 3%.

(1 + 0.050) = (1 + real return + debt risk premium) x (1 + 0.03)

Real return + debt risk premium = [(1 + 0.050) / (1 + 0.03)] – 1

Real return + debt risk premium =  1.94%

If it is estimated that the investment will have a risk premium relative to the 10% Government Debt.

1. The real interest rate of the investment including risk:

(real debt rate + debt risk premium) + risk premium =

0.0194 + 0.10 = 11.94%

2. The nominal interest rate of the investment including risk:

(1 + nominal rate) = (1 + 0.1194) x (1 + 0.03) = 1.1529   –> 15.29%

Therefore, the nominal rate of this investment will be 15.29%.

For the previous example, assume that the required market return for a specific investment is known to be 9%, which will be a nominal rate.

Calculation of the risk premium

But what is the risk premium implicitly included in this required return, relative to the 5% return on 5-year Government Debt in the secondary market?

We take into account that the previous inflation was 3%.

1. (1+0.09) = (1+real debt return + debt risk premium + risk premium) x (1+0.03)

2. (1+0.05) = (1+real debt return + debt risk premium) x (1+0.03)

Real return + real debt premium = [(1+0.05)/(1+0.03)]-1 = 0.01941

Then, in point (3), we substitute the previous addend and solve for the risk premium.

(1+0.09) = (1 + 0.01941 + risk premium) x (1+ 0.03)

Risk differential = [(1+0.09)/(1+0.03)] – 1.01941 = 0.0388

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