The Cap Rate and Discount Rate

Two of the most important metrics in CRE investment are the capitalization rate and the discount rate. The cap rate is applied to one year’s net operating income, while the discount rate is applied to a series of yearly NOI’s or net cash flows. While most seasoned real estate investors use the cap rate for valuation purposes, many do not incorporate the discount rate in their deal analysis.

The capitalization rate is determined by two methods; the net operating income of a property divided by its value or purchase price or by a formula. The formula is the risk-free rate plus a risk premium less a growth rate. The risk-free rate is usually U.S. Treasury securities, typically, the 10 Year T-Note, which is currently about 2.0%. The CRE risk premium is for the 15 risks inherent in CRE that were discussed in last month’s VOM issue. The risk premium has typically been between 3.0% and 10.0% and for this analysis, we will use 7.0%. The growth rate is the growth in a property’s income and with a bustling CRE market, it is estimated at 3.0%. Therefore, the formula cap rate would be calculated today as follows; 2.0% + 7.0% – 3.0% = 6.0%. This is an average cap rate and would need to be adjusted for property type and location.

The cap rate is only applied to a one-year net operating income to determine value because it already includes the growth rate, which in this example is 3%. Once the growth rate is deducted, the formula assumes the NOI will grow at 3.0% into perpetuity and is, therefore, a present value calculation. The cap rate is also related to corporate finance as the inverse of the EBITDA multiple (enterprise value divided by EBITDA) and the price-earnings ratio (stock price divided by the earning per share). The EBITDA multiple is used by Wall Street to value companies in merger and acquisition transactions and reveals the market value of the company’s debt and equity divided by its cash flow. The P/E ratio is the stock price per share divided by earnings per share and again is the inverse of the cap rate ratio.

The discount rate is the rate used to discount to net present value a stream of CRE cash flows over some time period, usually 5, 7 or 10 years. The stream of cash flows can be either the net operating income, net operating income after tenant improvements and leasing commission or net cash flow to the equity investor. The discount rate is determined from the first part of the cap rate formula as the risk-free rate plus the risk premium and in the example above, would be 2.0% + 7.0% or 9.0%. The growth rate is not deducted as in the cap rate formula because the discount rate is applied to a series of cash flows and not just a one-year cash flow. The growth rate or inflation factor is already included in the yearly proforma numbers. The discount rate is then used to discount the yearly cash flows and the terminal value of the property, which is determined by applying the cap rate to the next year’s cash flow. The discount rate will always be higher than the cap rate, as long as income growth is positive. Average discount rates used by most investors today are between 7.5% and 9.5%.

Many public REITs use the above calculations to determine their cap rate and discount rate. However, since they are public companies with secured and unsecured debt, preferred stock and common stock, they can also determine the discount rate by calculating their weighted average cost of capital (WACC) as taught in corporate finance. The WACC is the weighted average cost of the REITs, long term debt plus preferred stock if any, and common stock. The cost of debt is the yield on the debt times its weight in the capital structure and excludes the tax effect because REITs are not subject to income tax. The cost of preferred stock is the dividend divided by the price and the cost of common stock is determined by the capital asset pricing model (CAPM). The CAPM is the risk-free rate plus the stocks beta times the difference between the market return and the risk-free rate. Most of the large-capitalization REITs have WACCs of 10%-12%.

For example, the WACC for a generic mall REIT is 11.30% using the CAPM model. It’s calculated as the average risk-free rate of 3.0%, plus the stock beta of .74 times the difference in the expected market return of 15.0% less the risk-free rate of 3.0%. This is the rate the REIT should use if they are valuing a property using a discount rate analysis or as the minimum rate of return on any real estate investment. The WACC for public REITs is typically higher than for private real estate as they have lower levels of debt, which has a low cost and higher equity capitalization, which has the highest cost.

Joseph J. Ori is executive managing director of Paramount Capital Corp. The views expressed here are the author’s own and not those of ALM’s real estate media group.