I’m in the private real estate reading. I’m currently at the term and reversion approach section. Everything makes sense except for one part - they say to use the cap rate as the discount rate to arrive at the present value. Why would we use the cap rate as the discount rate? We never use r-g as a discount rate for equities, why would we do it with real estate?
Also, if cap rate = discount rate - growth rate, how could cap rate = discount rate?
Cap rate is for real estate what terminal discount rate is for equity.
They are both constant growth models, the proper discount rate to use for a perpetuity is the discount capturing all the inheret risks of the underlying asset, minus the expected sustainable growth rate indefinetly.
The cap rate is a discount rate adjusted for growth, which also gives you a discount rate. Discount rate is also synonym with miniumum required return, opportunity cost, or risk-adjusted return.
Well so this is what confuses me. Real estate has all these connections to equity valuation, but then for some reason it uses the cap rate to find present value.
Here’s an example to show why I’m confused…
Terminal value 5 years from now…
D1 = 10
r= 20%
g=10%
V = D1 / r-g = 10/0.1 = 100
Discounted 5 years at 20% cost of equity = 100/1.2^5 = $40.20
Take the same values and put it into a real estate question and you’d get a different value?
NOI = 10
r= 20%
g=10%
V = 10/0.1 = 100
Discounted 5 years at cap rate of 10% (20%-10%) = 100/1.1^5 = $62.11
How can I get a different value just because it’s real estate? Initially I thought maybe it’s because real estate is less risky than equity, but that reduced risk should already be accounted for in the discount rate.
Cap rate is only used for perpetuity. You don’t discount a cap rate for 5 years. It’s all or nothing.
To make it easier for you to remember, never use (1 + cap rate), because it’s a perpetuity yield adjusted for a series of infinite and constant growth.
I have an example in my notes where that’s exactly what they’re doing. They’re discounting a future perpetuity using 1+ cap rate.
No you don’t.
"The estimated rental value in 2 years based on current market conditions is 800,000 per year, and the cap rate on comparable fully rented properties is 6%. a 5% discount rate is considered appropriate to discount the term rent as it is less risky than market rent.
…
The present value of the reversion component of value is calculated as N = 2; I/y = 6; PMT = 0, FB = 13,333,333.33, CPT PV -> PV = 11,866,619.2
I left some parts out, but you can see they used the cap rate (on comparable properties) to discount to PV the reversion component.
Well technically, they could use the term cap rate as a substitute for discount rate. But the CFAI uses the cap rate almost exclusively for perpetuity calculations, since it’s the implied term for the discount rate adjusted for potential growth, age, cash flow, credit worthiness, and any other opportunity cost. While basic discount rates are the same but without subtracting a discount for growth potential.
You\d typically find cap rate on NOI for final values, and discount rates for interim periods.