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It is a common practice in the real estate business to use the direct capitalization approach (NOI/Cap Rate) to value real estate. However, this short-cut approach often leads to inaccurate valuations, as discussed in more detail on our cap rate formula page.
It is usually preferable to use discounted cash flow (DCF) analysis, although it does require a bit more work. The investor will have to take the time to make cash flow forecasts for each year during the projected holding period, including a projection of the sales proceeds expected in the final year.
To perform DCF analysis, the investor will need to determine an appropriate discount rate, which should equal the total rate of return that could be achieved through other investments with a similar risk profile. The cash flow projections and the discount rate are then entered into a spreadsheet or financial calculator to compute the value of a property using the Present Value (PV) function.
It is important to select an appropriate discount rate in computing the present value of a property. One way to determine it is by identifying the cap rate of a comparable property and then using part of the equation shown below to come up with the discount rate. This equation is used by stock investors to value companies and is called the constant growth perpetuity formula or the Gordon Model.
The equation is:
This equation can be modified to work for real estate investors by substituting real estate terms into the equation and re-writing it as:
The denominator (discount rate minus the NOI growth rate) is equal to the cap rate. Suppose a current cap rate at a comparable property is observed to be 6%, and NOI growth is expected to be 2%. In this example, the expected total return, or discount rate, would equal 8%. Note that this equation deducts Cap Ex from the NOI before dividing by the cap rate, so it may be necessary to adjust an observed cap rate lower before figuring out the discount rate.
It is important to note that a current cap rate does not equal the return on investment. The cap rate tells us what the cash on cash return is in the first year of the holding period assuming the investor paid all cash. It says nothing about potential appreciation or the proceeds that come from a sale. Investors will want to rely on the Internal Rate of Return (IRR) function to compute returns. The IRR function is able to deal correctly with uneven cash flows and debt financing. As such, it can show an investor the return on equity, something a cap rate does not do.The IRR function makes it easy for an investor to compare the projected returns on investment from two properties.
Since it is ideal to use DCF analysis rather than direct capitalization to value property, does it make sense to stop thinking about cap rates altogether? No. As discussed on the cap rate formula page, the direct capitalization approach can produce accurate valuations in certain circumstances. In addition, observed cap rates can assist with determining discount rates as noted above.
Perhaps most important, cap rates are commonly used as jargon in the industry. Buyers, sellers and brokers use current cap rates as a language to communicate about purchase prices. For example, a broker might say, "To get this deal done, you will have to pay a 6 cap." A knowledgeable investor should be able to talk in terms of cap rates as well as use DCF analysis.
Here are a few final questions to consider: Why does real estate sell for a much lower cap rate in New York City than in Cleveland? Is it true that a property selling for a high cap rate is a better investment than one with a low cap rate? As you may suspect, the real estate in Cleveland is not necessarily a bargain, nor is it necessarily overpriced in New York City. The varying cap rates should prompt the investor to think about and research three things: opportunity cost of not investing in alternatives such as stocks and bonds; risk associated with the property and market; and rental rate growth. These factors drive property valuation. It is the investor's job to ascertain whether the market is giving them the proper weight in its pricing of properties.
Investors can refine NOI projections and check current cap rates using the online Cap Rate Calculator at apartmentpropertyvaluation.com.