how to determine what capitalization rate to under the discounted cash flow method

What is the difference between a cap rate and a discount rate? Because these concepts are frequently confused, this article will talk over the difference between a capitalization charge per unit and a disbelieve charge per unit in commercial real estate, and go out yous with a clear understanding of the two concepts. As you follow along, you lot might also find our Discounted Cash Flow Valuation Guide helpful.

Kickoff, let'due south become over a couple of definitions, and then we'll swoop into a specific instance.

Cap Rate

The capitalization rate, often merely called the cap rate, is the ratio of Net Operating Income (NOI) to property asset value. So, for example, if a property was listed for $1,000,000 and generated an NOI of $100,000, so the cap rate would be $100,000/$1,000,000, or x%.

What is a cap charge per unit in commercial real manor useful for? Because private properties differ profoundly in size and magnitude, it's helpful to talk about belongings prices and values in a common language. Thinking of property value per dollar of current internet income achieves this objective.

The cap rate is just a measure that quantifies property value per dollar of electric current net income. Another mode to remember about the cap rate is that it's the inverse of the pop price/earnings multiple used in the stock markets.

Discount Rate

The discount charge per unit is the charge per unit used in a discounted cash flow analysis to compute present values.

When solving for the future value of money set up aside today, we compound our investment at a particular rate of interest. When solving for the present value, the problem is one of discounting, rather than growing, and the required expected render acts as the discount charge per unit. In other words, discounting is only the inverse of growing.

What is the discount rate used for in commercial real estate analysis? In commercial real estate the disbelieve charge per unit is used in a discounted cash menses analysis to compute a cyberspace present value. Typically, the investor'southward required charge per unit of return is used as a discount rate, or in the example of an institutional investor, the weighted average cost of capital. This ensures that the initial investment made in a property achieves the investor's render objectives, given the projected cash flows of the property. The intuition behind IRR and NPV is that information technology allows us to determine how much an investor should pay for a property, given his required rate of render, or disbelieve rate.

Cap Rate vs Discount Charge per unit

So, back to the original question – what'southward the deviation between the cap charge per unit versus the discount rate? The cap charge per unit allows u.s. to value a property based on a single yr'due south NOI. And then, if a property had an NOI of $80,000 and we idea information technology should merchandise at an eight% cap charge per unit, so we could guess its value at $one,000,000.

The disbelieve rate, on the other hand, is the investor'south required rate of return. The discount rate is used to disbelieve future greenbacks flows back to the present to determine value and business relationship'south for all years in the holding period, not just a unmarried twelvemonth like the cap rate.

If a holding's cash flows are expected to increase or decrease over the holding menstruum, and so the cap rate volition be a misleading performance indicator. Consider the post-obit two investment alternatives:

Both properties accept a cap rate of 10% based on the NOI in year one. Only clearly the cash flows are better for Building B and it therefore provides a higher rate of return. The exact rate of render can exist quantified using the Internal Rate of Return (IRR). Also, assuming equal risk, any rational investor should be willing to pay more for Building B because its future cash flows are expected to abound more than than Building A'southward. But how much more could you pay for Edifice B while yet achieving your required render?

By completing a multiyear discounted greenbacks flow analysis nosotros could quantify exactly how much we can pay for this property with a Net Nowadays Value (NPV), given an investor's discount rate. The cap rate, on the other hand, will not exist able to answer this question for united states. In brusque, while the cap charge per unit and the discount charge per unit may appear similar, they are two unlike things used for unlike purposes.

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Source: https://propertymetrics.com/blog/difference-between-cap-rate-and-discount-rate/

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