Implicit Interest Rates Simplified: Your Ultimate Guide
Last Updated on February 28, 2023 by Morgan Beard
When accounting teams come across the term implicit interest rate, a quick search will tell them that this refers to an interest rate that’s not explicitly stated, but that doesn’t begin to explain why this is such an important concept.
Implicit interest rates influence purchasing decisions, real estate value, and how investors allocate their money. It’s important for accounting professionals to not only know how to define and calculate implicit interest rates but also understand how it applies to the world of finance. Here’s a complete guide to the implicit interest rate.
What is an Implicit Interest Rate?
An implicit interest rate is an interest rate that’s not defined in a contract. So, rather than being explicitly stated, the interest rate is implied. In other words, the tenant’s executed lease’s implicit interest rate is implied. To help illustrate the concept, here’s an example of an implicit interest rate in a simple loan.
If you borrowed $500 from a friend and agreed to pay them back $600, you’ve entered into an agreement with an implicit interest rate. That’s because no interest rate was explicitly stated, but you agreed to pay $100 in interest on top of the $500 principal you borrowed.
Some simple math will show that you’re looking at an implicit interest rate of 20%. That’s because the $100 interest is 20% of the $500 principal.
Lease accountants have long been familiar with the implicit interest rate. Most lease agreements don’t specify the interest rate the lessee pays the lessor over the lease term.
After the adoption of new lease accounting standards like ASC 842 and IFRS 16, the implicit interest rate in a lease is more important than ever. Lessees must now recognize a right-of-use (ROU) asset and report lease liabilities and assets on their balance sheets, and lease interest is among the liabilities.
Why Understanding Implicit Interest Rates Is Important
The new lease accounting standards have made calculating the implicit interest rate on a lease an essential skill for finance teams across the globe. But knowing how to arrive at the figure is only part of the picture. It’s equally important to understand implicit interest rates and what they can tell you.
An implicit interest rate may influence whether your company enters into a lease agreement. Taking the rate into account, and the specifics of the asset to be leased, you may be convinced that an outright purchase with a conventional loan is better than experiencing volatile variable lease payments.
For instance, imagine if the implicit interest rate on a car lease is similar to the rates on a conventional loan. If the car is to be used by a salesperson who travels a lot, the ability to turn in the vehicle at the end of the term makes the lease look even better.
On the other hand, consider a work truck for your facilities maintenance team. Your company will likely get many years of use out of the truck. If the interest rate on a conventional loan compares favorably to the lease’s implied interest rate, you might opt for a purchase over a lease. The incremental costs and the annual payments of that lease may result in a total financial expense that is significantly less than the estimated value of that lease asset at the end of its term.
And that’s just the considerations for leases. Implicit interest rates also play a factor in other scenarios, like real estate, securities, and investing. Given all of this, it’s easy to see why understanding implicit interest rates or implied rates are important, especially in financing decisions.
The first step in gaining this understanding is to know how to calculate implicit interest rates.
Calculation of Implicit Interest Rates
Here is a basic two-step formula for calculating implicit interest rates:
Total amount paid/Principal borrowed = X
X-1 x 100 = implicit interest rate
If you plug in the example used above — borrowing $500 from a friend and paying back a total of $600 — it helps to illustrate how the formula works. Here’s the example’s numbers plugged into the first step:
$600/$500 = 1.2
Now that you know that X equals 1.2 in the example, subtract 1 and then multiply the result by 100 to arrive at the implied interest rate:
1.2 – 1 = 0.2
0.2 x 100 = 20
The formula verifies that the implicit interest rate on this example loan is indeed 20%. In the real world, there are more factors to consider when calculating implicit interest rates.
Factors That Affect Implicit Interest Rates
ASC 842 provides this guidance on implicit interest rates on lease contracts:
The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor.
As you can see, several factors will affect an implicit interest rate calculation on a lease: the present value of the underlying leased asset, the fair value, the payments, the number of payment periods, and more.
Some of the factors laid out by ASC 842 are typically only known to the lessee. This requires the lessee to make estimates or use an alternative rate, during their initial measurement.The standard allows companies to use its incremental borrowing rate when an implicit interest rate can’t be determined. Private companies can also elect to use a risk-free discount as a matter of accounting policy. Or using a modified retrospective approach, a lessee can apply a single discount rate to a similar profile of leases.
Much like the earlier example of borrowing money from a friend, someone may invest in a company or product and ask for a fixed amount to be repaid. From the investor’s standpoint, the implicit interest rate is the rate at which the present value of future payments is equal to their initial investment.
That means a wide range of financial and economic factors can impact an implicit interest rate. This includes:
- Inflation can affect the implicit interest rate because it degrades the value of future payments.
- If an investment’s perceived risk is high, investors may ask for repayment with a higher implicit interest rate, to help compensate for the added risk.
- Assets with lower liquidity may carry a higher implicit interest rate because they are not easily contributing to cash flow.
- Market conditions, like the supply and demand for a particular product, can also affect the implicit interest rate. These are some of the main factors that can affect the implicit interest rate, but it’s worth noting that the relationship between these factors and the implicit interest rate can be complex and can vary depending on the specific investment or asset.
All these factors and more have a direct impact on an investor’s implicit interest rate. This is especially true in the field of commercial real estate.
The Importance of Implicit Interest Rates in Real Estate
In real estate investment, implicit interest rates represent the effective interest rate on the investment, taking into account factors like property tax, insurance, and asset maintenance costs. The rate is often a key factor when investors are evaluating different investment properties.
To understand why this is the case, imagine two commercial properties with similar purchase prices. One of the properties has higher property taxes, maintenance costs, and insurance rates. The implicit interest rate on this property will be higher when compared to the other one.
The property with the lower implicit interest rate will be seen as a more attractive investment, as it has the potential for higher returns. This makes implicit interest rates important to both buyers and sellers in a given real estate market.
Buyers who have a good understanding of the implicit rates associated with different properties can make better decisions. Conversely, sellers with a good grasp on implicit interest rates are better prepared to accurately price their properties for the open market.
Other Applications of Implicit Interest Rates
So far, you’ve learned why implicit interest rates are important in lease accounting, investing, and real estate valuation. There are many related fields where implicit rates have a strong influence. Here’s how they work in a couple of different examples.
Commercial Mortgage-Backed Securities (CMBS)
Commercial mortgage-backed securities (CMBS) are investment products backed by a group of mortgages on commercial properties. These securities are typically issued in the form of bonds and sold to investors. Interest rates are not explicitly stated in the terms of a CMBS, so they have implicit interest rates.
These rates reflect the costs of borrowing money for commercial real estate properties, impacting both the loan principal and the interest rate. This could include any number of different mortgages on various property types, with mortgages of varying terms. With the figures on hand, the implicit interest rate of a CMBS can be calculated by taking the income generated by the mortgage pool and dividing that figure by the total amount of outstanding debt.
The resulting rate is the return on investment that an investor in a CMBS can expect to receive. Investors will compare the implicit interest rates of different CMBS products to help determine which securities are the most attractive investment. The rates also give investors an idea of the credit risks associated with the underlying properties in the mortgage pool.
Real Estate Investment Trusts (REITs)
A real estate investment trust (REIT) is a business organization that invests in real estate and then sells shares of stock in their properties. A REIT may directly purchase properties or purchase mortgages.
Much like a CMBS, the implicit interest rate influences the decision-making process of a REIT’s investors, as it sets expectations for the future performance of the REIT.
If the implicit interest rate is high, it is likely that investors expect to receive a high return on their investment. Demand for REIT shares is likely to be high in this case, driving up their prices. On the other hand, if the implicit interest rate is low, it suggests that investors have a more pessimistic long-term outlook.
As investor sentiment shifts and the performance of the REIT changes, so will the implicit interest rate. Therefore, REITs represent another investment type where implicit interest rates can significantly impact valuation and decisions made by investors.
The Future of the Implicit Interest Rate
In the future, the outlook is clear: the implicit interest rate will continue to be an important part of finance, investing, real estate, and accounting.
Consider the role that implicit rates now play in lease accounting. Before ASC 842 and IFRS 16, calculating the interest rate implied by a lease’s terms, the lease duration, and rental payments was often an academic exercise.
Perhaps some CFOs or accounting managers might have wanted to know the implicit interest rate before entering into a lease agreement. But since operating leases were not required to be captured on the balance sheet and only included in the notes of financial statements, an implicit rate calculation wasn’t always done.
With the new standards, every lease accountant now needs to be knowledgeable know a lot about implicit interest rates—what they are, how to calculate them, and what they mean to the bottom line. In a few short years, the implicit interest rate became critical knowledge.
In the world of real estate and investments, the implicit interest rate plays an equally critical role. It will help decide how an investor uses their money. When it comes to a CMBS or REITs, these rates directly impact the value of securities and return on investment.
In these cases, future implicit interest rates will be influenced by economic trends like inflation, base interest rates set by regulators, and a country’s productivity growth. Global central bank decisions on interest rates have a significant effect on economic growth and inflation, which filter down to implicit interest rates.
Given all these factors, making predictions about the implicit interest rate’s future can be tricky. One thing that always stays the same is the need for guidance in these matters. Be cautious and contact a financial professional for expert advice on implicit interest rates before making any decisions.
Occupier Helps You Master the Implicit Interest Rate
The implicit interest rate is now an essential component of lessee accounting. Your finance teams need to know how to calculate the implicit rate in your leases to maintain compliance with new standards like ASC 842 and the International Accounting Standards Board, IFRS 16. But those calculations are anything but straightforward.
For businesses that want to spend less time making calculations in spreadsheets and manually pulling data from your legacy accounting software, Occupier is here to help. We offer a full-featured system that manages the entire lease lifecycle for you. Utilizing a modern and innovative tech stack, Occupier’s solutions free up your internal teams, automate many of your processes, and help your teams master lease accounting and commercial real estate management. That includes the implicit interest rate—and any other lease and real estate concepts you’re likely to run into.To see how Occupier can help your business take control of your real estate portfolio and unlock opportunities, get in touch with us or request a demo today.
