Volume 1, No. 3, Fall 1996

Click here to download pdf file (844 MB)

Rates of Return: Direct Capitalization versus Discounting

What's the Difference?

Commercial real estate appraisers are often asked, "What is the difference between a 'cap' rate and a discount rate?" They seem the same. But are they? The source of the confusion lies primarily in the two distinctly different ways rates of return are expressed. Although not widely stated as such, most commercial real estate values can be expressed as a function of their net operating incomes. In the most basic of explanations, a property's net operating income is its forecasted revenues, less its forecasted expenses. Direct capitalization rates are the rates which equate potential net operating income to value. Discount rates take this process a step further. In addition to considering current income, they reduce a future income stream to present value.

Direct Capitalization Rate
The most basic use of a rate of return is the direct capitalization of net operating income. This represents a one-time snapshot of stabilized net operating income. A stabilized cash flow is one in which the property is not experiencing any extraordinary fluctuations due to external factors, such as onetime items of deferred maintenance or short-term leasing problems. The direct capitalization rate is essentially the one-year rate of return that the investor will accept for a given property. Direct capitalization rates can be expressed as a function of either the current or next year's net operating income. Before the widespread use of hand-held calculators and personal computers, direct capitalization was the only form of income capitalization, and one which was relatively easy to apply to a property's cash flow. One way to think of capitalization rates is that they represent the inverse of price earnings multiples (P/F ratios) used in the stock market.

Discounted Cash Flow and Discount Rate
Since roughly 1980, a second method of income capitalization, the discounted cash flow (DCF), has been popularized. This involves a multi-year analysis of a property and is generally too difficult to accomplish without a computer. Appraisers and investors use a DCF for more complex income-producing properties when the annual cash flow is forecasted to fluctuate with time. Prime real estate candidates to analyze with a DCF include multi-tenant properties, such as office buildings, shopping centers, and industrial facilities. In a perfect world where the existing leases and projected income stream reflect current market conditions, the value reached from a DCF should approximate the one estimated by direct capitalization. Although the holding period for commercial real estate varies from investor to investor and from property to property, appraisers have conventionally used a 10-year time frame to analyze properties. At the end of the tenth year, the property is forecasted to be resold.

A discounted cash flow represents the present value of two income components: (1) the return on and (2) the return of an investment. The return on an investment represents the present value of the prospective annual net operating incomes generated by the property during the holding period. The return of an investment represents the present value of the projected resale of the property at the end of the holding period. The rate at which future investment returns are discounted to present day is called, not surprisingly, the discount rate. Also called the internal rate of return (IRR), it is the rate of return equating the present value of the property to future investment returns.

Many readers of appraisals find the dual use of the direct capitalization and discounted cash flow methods confusing. The misunderstanding often arises because the direct capitalization rate usually differs from the discount rate used in the discounted cash flow. For example, a common direct capitalization rate for a one-year income is 10%, yet a discounted cash flow performed on the same property may use a rate of, say, 11.5% and arrive at a similar answer. Why? The most simple answer lies in the explanation that the direct capitalization rate of 10% is the single-year rate of return; the discount rate of 11.5% represents the single-year rate of return, plus or minus the expected percentage change in value of the property over a holding period. "Change" can include such factors as the annual increase or decrease in net operating incomes and overall risk of the investment.

Discount Rate = Capitalization Rate + Change Over the Holding Period
The above formula makes sense because most investors expect their investment returns to improve with time. The most simplified explanation of the difference between the two rates of 10% and 11.5% is that 1.5% represents the property's average annual appreciation in cash flow and, in turn, value. Accordingly, a good rule-of-thumb relationship between a property's direct capitalization rate and discount rate is to calculate the average annual growth in a property's ten year net operating income. In many cases, the difference between the direct capitalization rate and discount rate should approximate the annual appreciation in cash flow.

One major difference between direct capitalization rates and discount rates is that direct capitalization rates can be generally imputed from present market sales data, whereas discount rates generally cannot, primarily because they rely upon future sales of the property. It is common to find sales of commercial properties where a property's present or prospective net operating income data is known. Given a property's sale price and net operating income data, an appraiser can calculate the direct capitalization rate. In valuing a property, current market sales data can be gathered to validate or justify the capitalization rate selection. On the other hand, the calculation of a discount rate involves a future investment holding period and the determination of a forecasted sale price. Only after a property has been held, usually for 10 or more years, can an investor determine a property's actual discount rate or internal rate of return. This information is rarely exposed to the marketplace, and even if it is, it would be of little use to investors because it constitutes retrospective, not prospective, market data. For example, if it were proven that commercial real estate had yielded 15% over the last decade, does it mean that everyone expects a similar 15% yield in the next decade? Probably not.

In summary, a direct capitalization rate is indeed different from a discount rate. In direct capitalization, the rate converts one year's income into value. In the DCF, the discount rate is applied to a systematic pattern of income flows and a future sale price (reversion) that is specified as a percentage of change from the original investment. Both approaches are valid in the appropriate contexts; hence, appraisal reports use both rates to reflect investor motivations and expectations about income flows and profit.