THE DISCOUNT RATE FOR REAL ESTATE INCLUDES A LIQUIDITY PREMIUM AS IT CAN TAKE TIME TO ENTER OR EXIT REAL ESTATE AT ITS FAIR VALUE

15. C is correct. The discount rate for real estate includes a liquidity premium as it can take time

to enter or exit real estate at its fair value. Real estate returns also include a premium for risk

which is similar to an equity risk premium as their value is affected by a host of economic

factors. Real estate values are sensitive to economic cycles. Section 7. LO.m.

Set 2 Questions

The following information relates to questions 1 - 3.

Abe Harold, an equity analyst has recently joined Greenfield Advisers, a global economic

consulting firm that provides economic updates of the global economy, and forecasts the

macroeconomic variables impacting various financial markets. Cathy Huang, Harold’s

supervisor knows that he is still relatively new to macro forecasting models, therefore discusses

with him macroeconomic variables used in forecasting models. Huang first questions him about

the key components of a discount rate. Harold responds, “The uncertainty about future cash

flows is indicated in the discount rate which is composed of three components:

I. The return required by an investor on a real default-free fixed-income security analogous

to the expected return on an inflation-linked bond issued by a developed economy

government.

II. The additional return required for investing in a real default-free investment.

III. The additional premium required to compensate for the uncertainty about the asset’s

future cash flows.”

Huang then shows Harold some of the factors (refer to Exhibit 1) that influence a country’s

economic cycle and how they affect policy interest rates and fixed-income markets.

Exhibit 1: Important Economic Observations

Country Factors

China An aggregate increase in borrowing

Positive output gap

USA Volatile inflation expectations

Increasing equity risk premiums

Japan Increase in marginal utility from consumption

Increase in individual saving levels

Huang next asks Harold, about the relationship of current interest rates with inflation

expectations. Harold explains, “The difference between yields on a default-free real bond and a

default-free nominal bond of the same maturity reflects both future inflation expectations of

investors plus a risk premium for the uncertainty of future inflation.”