DEFINITION of Implicit Rental Rate
Implicit rental rates reflect a company's opportunity costs of doing business rather than allocating the resources used for alternative purposes. Derived by looking at the after-tax costs of all of a firm's capital resources including human (owners and labor), physical and financial, implied rental rates incorporate both a depreciation component and the interest the firm could have earned had it chosen to invest its funds instead.
BREAKING DOWN Implicit Rental Rate
Implicit rental rates can be understood as a category of implicit costs. They should be analyzed in relation to a firm's explicit costs of funding. Rent as used here refers to the concept of economic rent, the cost over and beyond what's required for production. While the implied rental rate can be either greater than or less than the firm's cost of capital, if the implicit rental rate remains lower than the firm's cost of capital for an extended period, the firm is not likely to be in business for much longer. This is because the firm's cost to operate its assets, is greater than the firm's best alternative use for those assets. Because a firm's implied, or user, cost of capital in part reflects management decisions made over time, calculating its implicit cost of capital and comparing it to industry peers' can provide insight into financial management decisions and the quality of a company's financial stewardship.
Where Else Do Implied Rental Rates Come Into Play?
Implicit or implied rental rates also come into play in evaluating potential investments in real estate. In that context, prospective buyers can compare the costs of renting (current market rental rates) versus owning a home (e.g., purchase and selling costs, taxes, insurance, maintenance, homeowners' association dues) to determine the relative attractiveness of each in a given housing market.
Implied rental rates are affected by prevailing interest rates, rates for human capital (wages), depreciation and tax policy regarding income taxes, tax credits and depreciation methods. Because they are not specified or quantified upfront, implicit rental rates are easy to overlook. However, taking them into account promotes better decision-making because it allows for the full costs and impact of decisions to be known and acknowledged.