A colleague of mine recently sent me a WhatsApp message inquiring about the rationale behind discounting future rents when capitalizing a ground rent. This query stemmed from his task of capitalizing an emphyteusis set to last until 2048.
The explanation is quite straightforward, and I find it worth sharing as this question often arises.
When capitalizing a future cash flow from a temporary emphyteusis that will eventually revert to the owners (ensuring reversion is possible, thus not prima facie impossible by virtue of Article 12 of Chapter 158), the aim is to calculate its present value. This process essentially involves discounting the cash flow to reflect the time value of money. However, an essential point to note is that the time value of money is a financial concept recognizing that a Euro received in the future is worth less than a Euro received today.
To give a complete perspective, the formula that discounts the future ground rent payments back to their present value, considering the time value of money is this:
Present Value = Annual Ground Rent/ [(1+Discount Rate)^Number of Years]
In this formula:
“Annual Ground Rent” is the amount of rent paid each year.
“Discount Rate” is the rate used to discount future cash flows. A straightforward formula to calculate discount rate is this:
Discount Rate =[(Future Property Market Value/Present Property Market Value)^(1/Number of Years)] −1
“Number of Years” is the total number of years for which you want to calculate the present value.
I wish to emphasize that the provided discount rate formula should be approached with caution, as it represents a simplified method. Real-world applications of the discount rate are subject to various influencing factors, such as the opportunity cost of capital, risk as well as inflation.
The term “opportunity cost” refers to the idea that having money today presents the chance to invest and earn a return, while receiving the same amount in the future entails missing out on potential earnings.
Inflation, a familiar concept, erodes the purchasing power of money over time, meaning a fixed amount of money will have less buying power in the future. Adjusting for this loss is crucial when discounting future cash flows.
Risk, inherent in future cash flows due to uncertainty, is addressed through the incorporation of a risk premium in the discounting process albeit it’s noteworthy that in the context of undervalued rent, the risk associated with not apportioning it is of minimal concern.
All this being said, the main takeaway from this contribution is to underscore the significance of present value calculations when capitalizing property rents. This essential step ensures that future cash flows are accurately represented in today’s Euros.
