D=Y(1-T)

The next item in the capital structure is preferred stock. If a company does not have preferred stock, this calculation would not be applicable. The cost of preferred stock is the dividend per share on the stock divided by the stock price. If PS is the cost of preferred stock, D is the dividend per share and P is the price per share, then the formula is:

PS=D/P

Calculating the cost of debt and preferred stock are fairly straightforward, however, the cost of common stock requires some financial formulas. There are two important formulas or models that are used to calculate the cost of common stock, the Dividend Discount Model (DDM) and the Capital Asset Pricing Model (CAPM). Per Wikipedia, The DDM is named after Myron J. Gordon, who originally published it in 1959, although the theoretical underpinning was provided by John Burr Williams in his 1938 text "The Theory of Investment Value" and the CAPM model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. The DDD model formula is the dividend per share divided by the stock price plus the dividend growth rate. This model posits that the expected return of a stock is equal to the dividend yield plus the expected constant growth rate of the dividend. If C is the cost of common stock, D is the dividend per share, P is the stock price and G the growth rate, then the cost of common stock using the DDM is:

C=D/P +G

A company's dividend growth rate is the expected growth in dividends over the next few years. If a company does not pay dividends then it must use the CAPM to determine the cost of common equity. The other and more popular model is the CAPM, which is the risk free rate plus Beta times the market return less the risk free rate. The CAPM posits that the expected return of a stock is equal to the risk free rate plus the non-diversified equity risk premium. If C is the cost of common stock, Rrf the risk free rate, B is Beta and Rm the market return, then the cost of common stock is:

C=Rrf+B(Rm-Rrf)

The Risk Free Rate is the rate on government Treasury securities and for this article we will use the current 2014 Ten Year Treasury Note rate of about 2.7%. Beta is a statistical measure of the volatility of a company's common stock relative to the market. For example, if a company's Beta is 1.5, then its stock is 50% more volatile than the market and if the market goes up 10%, this stock would go up 1.5 times or 15%. We will use an average Beta of .75 for this analysis. The market return is the expected return on the stock market and for this analysis we will use the expected return on the S&P 500 in 2014 of approximately 12%. The term in the parentheses, the market return less the risk free rate (Rm-Rrf) is also known as the equity risk premium or the additional return required by equity holders above the risk free rate Treasury note rate to hold risky REIT securities. There is a tremendous amount of data and analysis on the equity risk premium going back to the early 1900's by Ibbotson and others and historically it has been in the range of 4% to 8%.

The following table contains data to calculate the WACC for our hypothetical REIT, ART.

[IMGCAP(2)]

Using the data on ART above and the CAPM model, the WACC is calculated as follows

1. Cost of Debt is 4.75%(1-35%) =3.08%

2. Cost of Common Stock is 2.7%+.75(12%-2.7%) = 9.67%

Using the above costs and weights in the capital structure, the WACC is:

3.08% x 43%+9.67% x 57% = 6.8%

ART's WACC is 6.8% and this is the rate that should be used to evaluate all the firm's investment programs. The company should only undertake real estate investments that have a cap rate or internal rate of return (free and clear) that are greater than the WACC. All the firm's capital budgeting and corporate investments that yield a return in excess of the WACC or a positive net present value using 6.8% as the discount rate; will increase the value of the firm and stock price and the total return to its shareholders.

Although this analysis was based on a hypothetical public REIT, it should also be used by private real estate investment firms to determine their own WACC.

Joseph Ori is executive managing director of Paramount Capital Corp. The views expressed in this column are the author's own.