The Compass: Finding longitude in the discount rate
For centuries, sailors could determine their latitude by looking at the sky. Longitude was more troublesome. Everyone understood its importance, but the problem was measuring it reliably.
Real estate may have its own small version of the longitude problem. When building up a discount rate, we quantify much of what we can. We know the risk-free rate, analyse the sector and asset class, assess the lease, tenant and cash flow, and model future capital expenditure. And then there is location. But first, what actually goes into a real estate discount rate?
There is no single recipe, but I tend to think about five broad components. The risk-free rate and general market risk are perhaps the easiest starting point. Government bond yields and financial markets provide observable evidence. We can debate which reference is most appropriate, but at least we have numbers.
The same is true when we move to sector and asset risk. Residential, offices, logistics, retail, hotels and new developments do not carry the same risk. There is a pecking order, although that order can change over time and between markets. A stabilised residential investment, for example, presents a very different risk profile from a speculative development. There is still judgement involved, but there is plenty of market evidence to help us understand those differences.
Tenant and cash flow risk can also be analysed with a considerable amount of quantitative information. We know the rent and remaining lease term, can compare contractual rent with market rent and use credit ratings and financial information to assess covenant strength. At the other end of the spectrum sit capex, ESG and obsolescence. Technical due diligence, maintenance plans and energy performance provide evidence, but estimating future expenditure and obsolescence inevitably involves more assumptions about the future.
And somewhere between these sits location.
Location has traditionally been assessed through accessibility, market dynamics, vacancy, rental growth and liquidity. We know intuitively that an office next to a major railway station is not the same proposition as an otherwise identical office in a poorly connected location. Yet, while we quantify so many of the other inputs, we still have a tendency to describe location with words such as prime, secondary, accessible or simply good.
Nearly twenty years ago, Walk Score® helped change that thinking. Launched in 2007, it pioneered a deceptively simple idea: an aspect of location could be translated into a number. It helped make walkability measurable and understandable and brought location scoring into mainstream real estate thinking. Credit where credit is due, Walk Score helped write the rulebook.
But almost two decades later, both the data available to us and our ability to process it have changed considerably. For European real estate, the opportunity is therefore not simply to recreate a walkability score, but to broaden the question. How well connected is an asset by foot, by car and by public transport? What can actually be reached from the asset? Restaurants, shops, supermarkets, schools, healthcare, parks, coffee shops and entertainment can all tell us something about the quality and connectivity of a location.
That is the thinking behind the KR&A Connectivity Score. Using hyper-local data and modern algorithms, the score brings these different elements together. Pedestrian connectivity, for example, considers amenity access alongside infrastructure and reachability. Public transport adds factors such as proximity to stops, frequency and route diversity. Instead of simply saying that an asset is well located, we can start providing quantitative evidence as to how well connected that location actually is.
Does that mean the Connectivity Score determines the discount rate? Of course not. Neither does a credit rating, the risk-free rate or an ESG assessment. They are all inputs, and that is precisely the point.
Location is an important component when assessing real estate risk and therefore when building up and substantiating a discount rate. If we can add consistent, comparable and quantitative evidence to that component, the Connectivity Score becomes another useful input for the valuer or investment manager. It does not replace professional judgement. It helps inform it.
Perhaps that brings us back to our sailors. The compass never decided where the ship should sail. It gave the navigator better information with which to make the journey.
The KR&A Connectivity Score can play a similar role when building up a discount rate. It will not give you the answer, but it can help you navigate towards one.
