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CAP Rate And Discount Rate

CAP Rate And Discount Rate, The Relationship Between The Two

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Discount rates are comparable to cap rates in using a property’s net operating income to determine its value. However, unlike cap rates related to a property’s present NOI, discount rates factor in the property’s future cash flows.

It is a crucial distinction since the rate of return must consider added risk to account for future changes in the property’s cash flow. A discount rate is thus equal to the current market capitalization rate plus a risk premium.

But, is there any relationship between the cap rate and discount rate? Can the cap rate discount rate be used in the same breath? And how does each metric affect what you are willing to pay for a given asset? We look to provide the answers by defining both cap rate and discount rate, comparing them, and considering if they can be used in conjunction with one another.

Key Takeaways

  • The cap rate describes a property asset’s market value and net operating income. Although they both show a property’s annual rate of return, there is a significant distinction between the cap rate and discount rate.
  • A discount rate less than the anticipated long-term growth rate of potential earnings can be used to define a cap rate. As a result, to determine a cap rate, one must first determine the discount rate.
  • A DCF model might allow for the reasonable assumption that earnings would stabilize at some point in the future. In other words, the valuer makes earnings and income growth projections for a set period, say five years.

Cap Rate

The term “capitalization rate,” also known as “cap rate,” is frequently used in the real estate industry to describe the rate of return on an investment based on the asset’s NOI. 

Net Operating Income (NOI) divided by the asset’s current market value is the formula for calculating the Cap Rate.

NOI / Market Value = Cap Rate

Current Market Value of Asset

Cap rates are a primary determinant of value and return in commercial real estate investments. When real estate investors, for instance, buy an apartment complex, they disclose the yield they are prepared to accept. As investors increasingly view cash-flowing physical assets as a low-risk option to hold and grow value and earn good cash on cash returns, cap rates continue to compress.

CAP Rate Example in Action

Your gross operating income, less operating expenses, is your NOI. By reducing expenses, optimizing operations, collecting, raising rents, and adding additional income items outside of rent, you can increase the net operating income of your property. The higher your property’s NOI, the more the next real estate investor is willing to pay for that yield.

For instance, you would have an NOI of $60,000 if your monthly gross operating income was $100,000 and your monthly operational expenses were $40,000. This would reflect an annual NOI of $720,000.

Let’s use the example of John, an investor who wants to purchase an investment property, to understand the CAP Rate better. John lists the following three properties together with their associated costs, yearly incomes, and market values: 

Property

Annual Income

Annual Expenses

Market Value

Cap Rate

A

$100,000

$7,500

$891,000

6.17%

B

$250,000

$112,000

$2,346,000

5.88%

C

$300,000

$129,000

$1,800,000

9.5%

John discovers that Property C has the highest cap rate after performing the computations for the properties mentioned above.

In an ideal world, John might decide to buy something based on the price. But as we know, price and CAP rates are only one of several criteria that may be used to evaluate the return on a piece of commercial real estate. Just because the property has a high in-place CAP rate, it doesn’t necessarily mean that future cashflows will continue to grow at the same rate as a property that was maybe a 5.88% in-place CAP rate, like in example B.

Although the cap rate is a valuable indicator of a property’s potential return on investment, it should be used in tandem with other indicators like the gross rent multiplier, the IRR, and various other factors.

As a result, other measures should be utilized in addition to the capitalization rate to determine how attractive a real estate investment is.

Discount Rate

The discount rate is frequently used to calculate the present values of future revenues from many sources, including property and business ventures. When applying the so-called Discounted Cash Flow (DCF) model to determine a real estate’s current value (PV) or net present value of its net cash flows, the real estate discount rate is utilized in particular.

The needed rate of total yearly return for properties like the one under evaluation by real estate investors engaged in the local property market at the assessment point is known as the real estate discount rate.

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When evaluating real estate investments, discount rates are used to analyze the feasibility of cash flows and present and future valuations. You can determine the best properties to purchase for future profit by examining how this rate of return will affect your investing goals.

It’s critical to pick the appropriate amount for your computations because the discount rate affects the property’s net present value. You must select a discount rate for commercial property that considers the opportunity cost of making a different investment. If the second property of comparable size and risk is already on the marketplace, the investor could choose a discount rate that equals that rate of return.

Consider the property’s features, the local macroeconomic environment, and any other hazards that may arise during a practical property assessment, such as market direction and contract expiry. The discount rate is always based on NPV.

Discount Rate Example in Action

The discount rate can be viewed in two different ways. The discount rate is initially defined as the rate used to calculate the current value of future cash flows. The second is to imagine the discount rate as the rate of return an investor needs to accept the risk of investing in real estate.

In any case, the percentage that results is used to calculate the present value of a source of future cash flows.

It’s crucial to distinguish between the discount rate and the discounted cash flow analysis, or DCF, type of study that uses it. The analyst’s assessment of three factors—the desired rate of return, risk perception, and market direction—influences the choice of the discount rate more than its calculation.

Assume a real estate investor is thinking about buying a property that generates the following cash flows: $100,000, $115,000, $125,000, $140,000, and $150,000. Assume that the investor’s needed return rate, or discount rate, is 8%. So, how much are these cash flows discounted at an 8% rate today? The response is summarized in the table below: 

Year

Cash Flow

1

$100,000

2

$115,000

3

$125,000

4

$140,000

5

$150,000

NPV

$495,407.25

At an 8% rate of return, the net present value of this sequence of property cash flows is $495,407. However, this does not necessarily imply that this is the asking price for the property. Instead, it should be considered with several other considerations, such as the cap rate, as one input into the decision.

CAP Rate vs. Discount Rate

The capitalization rate is a different commercial real estate measure occasionally used to compare the discount rate.

The cap rate describes a property asset’s market value and net operating income. Although they both show a property’s annual rate of return, there is a significant distinction between the cap rate and discount rate.

Because value plays a significant role in the computation, the market drives the cap rate. Since it represents an investor’s required rate of return, the discount rate is more arbitrary. But you may use them both to determine what a property might sell for in the future. In actuality, they are frequently combined.

How the CAP Rate & Discount Rate Can be Used in Conjunction

A discount rate less than the anticipated long-term growth rate of potential earnings can be used to define a cap rate. As a result, to determine a cap rate, one must first determine the discount rate.

A DCF model might allow for the reasonable assumption that earnings would stabilize at some point in the future. In other words, the valuer makes earnings and income growth projections for a set period, say five years.

Earnings are expected to level after five years and expand very little further. The capitalization rate is used to determine the terminal value or the value of future earnings after five years. In other words, profits are anticipated to remain constant over the following five years.

Frequently Asked Questions About The CAP Rate and Discount Rate

As used in the corporate finance literature, the weighted average cost of capital (WACC) and the capitalization rate have a close relationship. The WACC is a discount rate representing the average rates of equity and debt capital a company uses.

The discount rate applies to annual NOIs or net cash flows, whereas the capitalization rate applies to NOI for one year. Many experienced real estate investors do not utilize the discount rate in their purchase analysis, even though most use the capitalization rate for valuation purposes.

CAP Rate Discount Rate - Conclusion

By performing a multiyear discounted cash flow analysis, we may determine the exact amount we can spend on this property using a Net Present Value (NPV), assuming an investor’s discount rate.

On the other hand, the cap rate won’t be able to provide us with an answer. In summary, even though the cap and discount rates may seem identical, they are two distinct concepts with different uses.

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Sources:

  1. Investopedia, “Discount Rate
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