How to Calculate a Discount Rate

CRE practitioners frequently discuss the calculation and application of capitalization rates in making investments, however, there is not much posited on the discount rate used in CRE financial analysis. As you recall, the capitalization rate is determined by two methods; the net operating income divided by property value or by a formula. The formula is the risk-free rate plus a risk premium less a growth rate. The risk fee rate is U.S. Treasury securities, typically, the 10-Year T-Note, which is currently 4.20%. The CRE risk premium, which I believe has typically been between 3% and 10%, however, there is virtually no historical information or data on this rate. For this analysis, due to higher interest rates and lower values,  we will estimate it at 7%. The growth rate is the growth in a property’s income and with the current soft CRE market, it is estimated at 2.0%. Therefore, an average cap rate would be calculated today as follows; 4.20% + 7% – 2.0% = 9.20%.

This is an average cap rate and must be adjusted further for specific property types and location. For example, if the project is an industrial warehouse in Miami, the risk premium can be reduced to 5.0% and the growth rate increased to 3.0%, for a cap rate of 6.20%. The cap rate is only applied to the one-year net operating income to determine value because it already includes a growth rate, which in this example is 2.0%. The cap rate is also equivalent to the inverse of the EBITDA multiple (enterprise value divided by EBITDA) and the price-earnings ratio (stock price divided by the earnings per share) used in corporate finance.