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How come a CAP rate can be different than the discount rate used in DCF valuation of RE property valuation? For example, a lessor’s ground lease valued with a 6% discount rate because of a national tenant holding leasehold interest. Those income streams of 25 years from this tenant are valued to arrived at a total valuation. But then doing a direct cap, a 5% is used? Both back into the same value over all? This is a real example. Thank you.
Hi Ryan,
For the academic answer, I’ll point you to a white paper that describes the difference between the discount rate and cap rate.
‘Real Estate Capitalization Rate Interpretations through the Cycle‘
The key part comes on page 12 – ‘Real Estate Cap Rate Defined’. You’ll notice that Dr. Corgel defines the cap rate (R) as the discount rate (r) minus the assumed growth rate (g).
So to answer your question, ” How come a CAP rate can be different than the discount rate used in DCF valuation of RE property valuation?”
The answer is growth. Without growth, the discount rate is equal to the going-in cap rate.
I’ve built a quick DCF to illustrate this point (click here to download the Excel file).
Notice in the attached example, the first DCF example assumes no growth in operating income nor in value growth. As a result, the internal rate of return (i.e. the discount rate at which NPV = 0) is equal to the going-in cap rate. However, when you bring growth into the equation (the 2nd DCF example) the internal rate of return (i.e. the discount rate at which NPV = 0) is higher than the going-in cap rate.
Let me know if you have any questions.
Spencer
Thank you very much!
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