Commercial real estate investors often underestimate the risk of debt when considering commercial real estate equity opportunities. They would rather focus on the upside of the deal without sufficiently adjusting their return requirements for the risks taken. One way investors can quantify debt risks is to use the weighted average cost of capital.
The weighted average cost of capital (WACC) is an economic ratio that determines a business’s cost of acquiring and financing assets by comparing the equity and debt structure of an organization. In simpler terms, WACC is how much a company pays for the funds it uses to operate. A business’s WACC is determined by its capital structure, which is a combination of debt and equity the company uses to finance its operations and growth. The cost of capital can include debt accounts, the shareholder’s equity accounts, and new common stock.
You can determine a company’s WACC by dividing the market value of its equity by the total market value of its equity and debt multiplied by the cost of equity multiplied by the market value of its debt by the total market value of its debt and equity multiplied by the costs of debt times one minus the corporate income tax rate.
While that’s quite a mouthful to spell out, the equation looks like this:
[(E ÷ V) x Re] + [(D ÷ V) x Rd] x (1 – T) = WACC
E = market value of equity
V = total market value of combined debt and equity
Re = cost of equity
D = the company’s total debt, or the market value of debt
Rd = cost of debt
T = total market value of combined debt and equity
The WACC helps the property management determine whether their business should finance the purchase of new assets with equity or debt by comparing the prices of both options. The management team can pass this data along to a potential investor to show them how the deal will be funded. In commercial real estate, debt is typically cheaper than equity as it is repaid first and has a first lien on real estate collateral until it’s paid off.
