Joseph Ori, executive managing director of Paramount Capital Corp.

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.