As discussed in my article, What’s a Cap Rate?, a capitalization rate is the unleveraged return generated by an income producing property; meaning if an investor bought a property all-cash (no financing) the cap rate would reflect the ratio of the property’s net operating income (NOI) to the purchase price. For example, if a property’s NOI is $100,000 and is purchased for $1,000,000 the cap rate would be 10%. Cap rates are used to calculate an asset’s value using the direct capitalization method in which the property’s net operating income is divided by the cap rate.
Cap rates are constantly changing because they are determined by the interaction of the capital market and space market, which are also in constant flux. Cap rates vary by market, asset type, asset class, etc. and reflect the demand for and risk associated with an asset. Market cap rates can be calculated through an analysis of recent sales comps but are still relatively subjective as they indicate how much an investor is willing to pay for a dollar of NOI.
Discount rates are similar to cap rates because they too are used to calculate value using a property’s net operating income; however, discount rates are applied to future income streams while cap rates are applied to a property’s current NOI. This is an important distinction because additional risk must be factored into the rate of return to account for potential changes to the property’s income. Therefore, a discount rate can be defined as the current market cap rate plus a risk premium. Like the direct capitalization method, a discounted cash flow analysis calculates an asset’s value by dividing future net income streams by the discount rate. Using the previous example, an investor may apply an additional 2% risk premium to the 10% market cap rate for a discount rate of 12% thus lowering the price they are willing to pay for the same asset to $833,333.33 ($100,000 ÷ 12%).
While market cap rates do reflect elements of risk, discount rates provide a more comprehensive approach to property valuation and are particularly useful when calculating the value of multi-tenant properties and multiple income streams. Every tenant’s risk profile is different and leases expire at different times. The discounted cash flow model allows investors to apply individual discount rates to specific income streams to account for the opportunity cost associated with each. The discounted income streams are then added together to calculate the price an investor is willing to pay for an asset which reflects their confidence in each income stream and risk tolerance.