The cost of capital for a REIT. The cost of capital is the rate of return required on a new investment. It can be misleading as it is often used in two way. One, company that uses debt and equity to finance its acquisition will consider the return required by those stakeholders in considering new projects. Any project that demonstrates a return less than the company's existing cost of capital will be hopefully ignored. A pure definition of the cost of capital, in the valuation context, is how we measure the riskiness of future cash flows so that we can properly value them today. In either situation, the WACC is the cost of equity and the cost of debt times the proportion of each in the desired or target capital structure. In this form, it is a relatively straightforward equation. However, in reality, it is very complicated. Getting the WACC correct is extremely important as it can alter the valuation immensely and getting the cost of debt and especially equity correct is very challenging. A more detailed formula sheds a little more light on how we calculate the weighted average cost of capital. Weighted average cost of capital is equal to K sub e, which is the required return on equity times the market value of the equity over the market value of the equity plus the market value of the debt. This is then combined with the cost of debt, representative as K sub d times the market value of the debt over the market value of the equity plus the market value of the debt. It is very important that we use the market values of both the equity and the debt. It is quite common in a WACC calculation to take the after tax cost of debt or K sub d, because of the tax shield that interest brings. However, because we're dealing with REITs where they typically do not pay taxes at the corporate level, we ignore that tax shield. We will first take a look at K sub b, or the cost of equity and this is often estimated using the capital asset pricing model. For the capital asset pricing model, we begin with the risk free rate. This is the return the investors require for taking no risk. Typically, we will use a 10 year benchmark government bond yield. We then add to this the risk premium for taking equity risk. This is the additional risk that the investors require to invest in overall equity market. We multiply that difference times beta, which is the additional risk investors required to compensate for non-diversifiable stock specific risk. In general, any betas that are greater than one are riskier than the market, and any betas less than one are less risky than the market. REIT betas tend to be less than one. The cost of equity is very difficult to calculate. Occasionally you will read that cap rates and FFO yields can be used as approximations for cost of equity. We have to be careful when doing this because these nominal rates are effectively based on a current or one year out earnings, and the true cost of equity is a long-term rate. Secondly, real estate is very sensitive to interest rates. And periods of rising or falling rates can change value and returns immensely. And finally, REIT returns are also affected when expected returns of other investments fall. This is because real estate is generally considered to be a place where people go to for safer returns based primarily on the dividends that many REITs pay. The cost of debt can be much more easy to calculate. Again, we wanna be sure we're using the market values of debt whenever we can. Most REITs have significant amounts of leverage and as a result, they will have many, many, many issuances of debt. One can actually go crazy trying to find the market value of all these pieces of debt. However, we can take some comfort in the fact that the market value of debt is often not dramatically different from the book value of debt. It is always best whenever possible to research the market values of debt. However, if it is not possible and in some cases, for example, with debt that is unrated or debt that is not publicly traded, in those situations it is certainly acceptable to use the book value of the debt. Alternative solution would be to go to benchmark companies, perhaps companies that are trading publicly or with similar credit ratings and try to find a cost of borrowing that is suitable. A WACC calculation should always be based on a target capital structure. A peer group analysis, which is based on a set of comparable companies can give guidance as to the expected long-term capital structure. In this example, we have five residential or apartment sector REITs and we see that their debt as a percentage of debt and equity is basically between 22 and 30%. Upon closer examination, we see that Avalon Bay at 22% is more of the outlier and that the median range seems to be between 25, 26 and around 30%.
