Discount rate
This page explains how to choose a discount rate in practice, without building it up from abstract components. The focus is on selecting a rate by comparing the investment with real, observable alternatives that carry similar risk.
How discount rates are chosen in the real world
Most investors do not calculate a discount rate by pricing individual risk components. That approach looks precise but is rarely realistic.
In practice, discount rates are chosen by asking one core question:
“What return could I reasonably earn elsewhere, taking a similar level of risk?”
The discount rate is then set at, or slightly above, that return.
Start with real alternatives, not theory
You should only compare against investments that you would actually consider instead of the property.
Examples of realistic alternatives:
- other rental properties in similar locations
- property funds or REITs
- equities with similar volatility
- private investments with similar illiquidity
If the alternative is not something you would genuinely invest in, it should not anchor your discount rate.
A practical example: choosing a discount rate for a rental property
You are evaluating a residential buy-to-let property.
Before choosing a discount rate, you look at what investors are currently earning in similar opportunities.
Observed market returns
| Investment type | Typical return |
|---|---|
| Prime residential property | 4–5% |
| Standard buy-to-let | 5–6% |
| Higher-risk or value-add property | 7–9% |
| Broad equity market (long term) | ~7% |
These are not theoretical numbers. They are outcomes investors are actually accepting in the market.
Placing the property on the risk spectrum
You then ask where this specific property sits relative to those alternatives.
Example judgement
- location: average, not prime
- tenant demand: stable but not guaranteed
- leverage: moderate
- exit market: reasonably liquid
This feels closer to a standard buy-to-let, not a prime asset and not a high-risk project.
Selecting the discount rate
Based on the observed alternatives:
- prime property at 4–5% is too low
- value-add property at 7–9% is too high
A discount rate of around 6% is consistent with how the market prices similar risk.
This rate answers a very practical question:
“If this property cannot deliver 6%, why would I not choose a comparable investment that already does?”
Using the discount rate in decision-making
Once chosen, the discount rate is used consistently.
For example:
- at 6%, the present value of cash flows is £196,500
- the purchase price is £200,000
This tells you the investment is slightly unattractive relative to alternatives.
The discount rate is doing its job: forcing a comparison against real options, not abstract benchmarks.
A second example: higher-risk property
You now assess a different property.
Characteristics
- short leases
- refurbishment required
- stronger potential rental growth
- more uncertainty around exit value
You compare it with:
| Alternative investment | Return |
|---|---|
| Stabilised buy-to-let | 5–6% |
| Value-add property projects | 7–9% |
| Small private equity deals | 8–10% |
This property clearly sits in the higher-risk bracket.
Choosing a discount rate below 7% would understate the risk.
A discount rate of 8% is consistent with what investors demand for similar uncertainty.
Why this approach works
This method is:
- grounded in real market behaviour
- easy to explain and defend
- resistant to false precision
- aligned with actual capital allocation decisions
It accepts an important truth:
Discount rates are discovered in markets, not calculated on spreadsheets.
Common mistakes to avoid
- comparing with investments you would never actually choose
- using a “standard” discount rate for all properties
- lowering the rate to justify a preferred deal
- ignoring changes in market returns over time
If market returns move, your discount rate should move too.
Key point to remember
A discount rate is not a personal opinion and not a mathematical construction.
It is a reflection of what real alternatives are offering for similar risk. If an investment cannot compete on that basis, the numbers are telling you something important.