Commercial Real Estate Analysis and Investments, D. M. Geltner, N. G. Miller, J. Clayton, P. Eichholtz
Depreciation Tax Shield in Real Estate
When investing in real estate, significant attention is given to the tax savings derived from depreciation (Depreciation Tax Shield – DTS), and this benefit becomes even more valuable when financial leverage is used.
In the table below, the left two columns show the pre-tax and post-tax IRR of cash flows when purchasing a property without a loan, while the right two columns illustrate the case of financing 75% of the purchase with debt.
Notice that in the right-side scenario, the difference between the pre-tax and post-tax IRR of cash flows is smaller compared to the left-side scenario (72% vs. 87% ratio).
The key factor in this phenomenon is the impact of depreciation expenses because if we eliminate them, the following picture emerges:
P.S.
Why isn’t the Depreciation Tax Shield emphasized as much when valuing corporations?
In corporate valuation, attention is given to all tax shields if the Operating Cash Tax Rate is used when calculating WACC. However, since this calculation is relatively complex and doesn’t result in significant differences, the Effective Tax Rate is commonly used instead—more specifically, Operating Cash Taxes.
Unlike corporations, in this case, depreciation is a key parameter since we are dealing with a purely tangible asset. Moreover, even though asset revaluation is regularly performed in REITs, tax regulations do not allow changes in depreciation parameters. This creates a valuation imbalance between buyers and sellers—buyers can depreciate the asset based on the new (higher) value.
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Commercial Real Estate Analysis and Investments, D. M. Geltner, N. G. Miller, J. Clayton, P. Eichholtz