What is the discount rate?
In the financial realm, the term discount rate refers to one of two things:
- The first is the interest rate charged when banks take out short-term loans from the Federal Reserve.
- The second is used to determine a cash flow’s net present value or the sum of all positive and negative future cash flows.
The first thing to understand about discount rates is that the term has multiple meanings in the financial world. Essentially, there are two key meanings for the term discount rate.
The first refers to the Federal Reserve’s interest rate for short-term loans provided to banks. The Federal Reserve raises and lowers the discount rate to encourage banks to be more conservative or aggressive in their lending practices throughout various economic times.
The second refers to using a discount rate or the discounted rate of return to determine what a cash flow is actually worth in the present, based on its anticipated future value. In addition, the discount rate is used to determine a cash flow’s net present value or the sum of all positive and negative future cash flows. Overall, determining a cash flow’s worth is referred to as a discounted cash flow analysis.
How to calculate discount rate for real estate
Calculating the discount rate for real estate is a multi-step process. To calculate the discount rate for real estate, an investor will first need to collect the following information:
- Initial cost. This can be either the purchase price or the down payment made on the property.
- Holding period. Holding periods are most often calculated for between five and 15 years.
- Additional year-by-year costs. These costs refer to projected maintenance costs, repair costs, property taxes, and other costs besides financing costs.
- Projected cash flows. This refers to a year-by-year projection of rental income that will be received from the property.
- Sale profit. This refers to the projected amount of profit that will likely be realized upon the sale of the property at the end of the projected holding period.
Discount rate case study
A bank could get a loan from the Federal Reserve after making an unusually high number of loans in a day. The bank would then need to pay the loan back to the Federal Reserve within 24 hours, or they would begin to pay interest. This charged interest rate would be the current discount rate.
The discount rate can also determine a company’s net present value or a property’s net present value. In this respect, a discount rate calculation would give an investor a better picture of a business’ or a property’s potential to make consistent revenue.
The bottom line
The most crucial element to remember when it comes to the discount rate is that there are multiple definitions for this term in the financial realm. Along with serving as a definition to explain the interest rate charged when banks take out short-term loans from the Federal Reserve, the discount rate is also used to help determine an assets’ future value.
