What Are Cap Rate and Discounted Cash Flow?
Cap Rate
Cap rate is short for “capitalization rate” and is one of many metrics used by commercial real estate investors when evaluating deals. The cap rate is usually expressed as a percentage, and is equal to a building’s annual net operating income (NOI) divided by its current market value.
For example, if the current market value of an apartment building is $1,200,000 and it generates $60,000 per year in net operating income, the building would have a cap rate of 5%:
Cap Rate = Annual Net Operating Income / Current Market Value = $60,000 / $1,200,000 = 0.05 = 5%
Investors use cap rate to gauge their return on investment. A higher cap rate means a higher return. But keep in mind that cap rates are only a snapshot of how well a property is operating. Cap rate changes any time the market value or net operating income goes up or down.
For example, if the market value of the apartment building above changes from $1,200,000 to $1,600,000 but it still generates the same $60,000 per year in net operating income, the building would have a cap rate of 3.75% instead of 5%:
Annual Net Operating Income / Current Market Value
$60,000 / $1,600,000
0.0375
3.75%
If the market value of the apartment building above was still $1,200,000 but the net operating income increased from $60,000 to $85,000, the cap rate would be 7.08%, not 5%:
Annual Net Operating Income / Current Market Value
$85,000 / $1,200,000
0.0708
7.08%
Analyze Market Trends with Cap Rate
Cap rate is not just a tool for analyzing deals. It’s also a great way to spot market trends. Looking at cap rate over time for a particular area or type of building can give you an idea of where the market is heading. If the cap rate for an area trends down, this can be a sign of increasing market value or decreasing net operating income. If the cap rate for an area trends up, this can be a sign of decreasing market value or increasing net operating income.
There are many factors that can influence the cash flow of a building, including:
* The age of the property
* The credit worthiness of the tenants.
* The type of tenants.
* The type of tenant leases in place.
* Local population growth and employment.
* General supply and demand for that type of building in that area.
The best use of cap rate is to analyze deals where the cash flow is constant. If the cash flow for a property is complex, irregular, or hard to predict, it’s better to use a full discounted cash flow (DCF) analysis to gauge return on investment.
Discounted Cash Flow
Real estate investors use discounted cash flow as another way to evaluate deals. Discounted cash flow is usually expressed as a dollar value. It’s calculated by adding together all the projected free cash flow over the life of the investment, divided by some discount rate. The result is called the “present value” of the investment. If the present value is higher than the actual cost of the investment, the opportunity might be worth buying.
The formula for discounted cash flow is:
Present Value = [Cash Flow A / 1 + Discount Rate) ^ 1] + [Cash Flow B / 1 + Discount Rate) ^ 2] + … + [Cash Flow X / 1 + Discount Rate) ^ X]
The discount rate can be the inflation rate, cost of capital, or any other percent that makes sense for your specific deal.
For example, if a building generates $30,000 in free cash flow in Year 1, $40,000 in Year 2, and $25,000 in Year 3, and we discount the cash flow by 5% each year, the Present Value of this deal would be $86,449.02:
[Cash Flow A / 1 + Discount Rate) ^ 1] + [Cash Flow B / 1 + Discount Rate) ^ 2] + [Cash Flow B / 1 + Discount Rate) ^ 3]
[$30,000 / (1 + 0.05) ^ 1] + [$40,000 / (1 + 0.05) ^ 2] + [$25,000 / (1 + 0.05) ^ 3]
[$30,000 / 1.05] + [$40,000 / 1.1025] + [$25,000 / 1.1576]
$28,571.43 + $36,281.18 + $21,596.41
$86,449.02
When doing a discounted cash flow analysis it’s important to remember garbage in, garbage out. the result is only as good as the projections and discount used as the inputs. Small changes to the inputs can result in large changes in the final result. Always remember to use accurate inputs when running a discounted cash flow analysis.