The discount rate is the annual rate of return an investor requires to convert a property's projected future cash flows into present value. It reflects both the time value of money and the risk of those cash flows, so riskier properties carry a higher discount rate. The discount rate is the central input in discounted cash flow analysis and the net present value formula.
What Is the Discount Rate?
The discount rate is the annual percentage used to translate a future dollar into what it is worth today, because a dollar received later is worth less than a dollar in hand. In a discounted cash flow model it is applied to every projected year of net operating income and to the sale proceeds at the end of the hold. A higher discount rate produces a lower present value, and a lower rate produces a higher present value.
Symbol | Meaning |
|---|---|
CF | Projected cash flow in a given year |
r | Discount rate, the required annual return |
n | Number of years until the cash flow is received |
PV | Present value, CF divided by (1 plus r) raised to n |
Per Altus Group, discount rates for most commercial real estate transactions fall in a representative range of about 5 percent to 12 percent, set by property risk, location, and market conditions.
How Is the Discount Rate Used?
The discount rate is used to sum the present values of all future cash flows into a single value estimate, the core of discounted cash flow valuation. Each year's cash flow is divided by (1 plus r) raised to the power of the year, then all the results are added together. The total is the most an investor should pay today to earn the required return.
The discount rate is also tied to the internal rate of return. The internal rate of return is the discount rate at which a property's net present value equals zero. If the internal rate of return exceeds the required discount rate, the deal clears the investor's hurdle. If it falls short, the price is too high for the return demanded.
Why the Discount Rate Matters
The discount rate matters because small changes in it swing the valuation by large amounts, especially for cash flows far in the future. A property valued at an 8 percent discount rate is worth materially less at 10 percent, because the reversion in the final year is divided by a larger compounding factor. This sensitivity makes the discount rate the single assumption most worth scrutinizing in a model.
The rate also encodes a view on risk. Raising the discount rate is how an underwriter charges for uncertainty in rent growth, tenant credit, or exit pricing. Two analysts modeling identical cash flows can reach different values purely through the discount rate they choose.
Example
An investor models three years of cash flow, with the third year including sale proceeds, and discounts each at 8 percent. Every year's cash flow is divided by (1.08) raised to that year's power, then the present values are summed.
Year | Cash flow | Divisor at 8 percent | Present value |
|---|---|---|---|
1 | $500,000 | 1.0800 | $462,963 |
2 | $520,000 | 1.1664 | $445,816 |
3 | $10,000,000 | 1.259712 | $7,938,322 |
Total | $8,847,101 |
The model says the property is worth about $8,847,101 today to an investor requiring an 8 percent return. Raise the discount rate to 10 percent and the same cash flows are worth less, because the large year-three reversion is divided by a bigger compounding factor.
Discount Rate vs Cap Rate
The discount rate and the capitalization rate are related but measure different things, and swapping them misprices a deal. The cap rate applies to a single year of net operating income to estimate value, treating income as level. The discount rate applies across a multi-year projection and accounts for growth in cash flows over the hold.
The two connect through growth. In simplified terms, the discount rate roughly equals the cap rate plus the expected annual growth rate of cash flow. A 6 percent cap rate paired with 2 percent expected growth implies a discount rate near 8 percent. The cap rate is a snapshot, and the discount rate is the full film of the cash flows over time.
Frequently Asked Questions
What is the discount rate in real estate? The discount rate is the annual rate of return an investor requires to convert a property's future cash flows into present value. It reflects the time value of money and the risk of those cash flows, and it is the central input in discounted cash flow analysis.
How is the discount rate used in valuation? The discount rate is used to divide each year's projected cash flow by (1 plus the rate) raised to that year's power, then sum the results into a single present value. That total is the most an investor should pay today to earn the required return.
What is the difference between a discount rate and a cap rate? A cap rate applies to a single year of net operating income and treats income as level, while a discount rate applies across a multi-year projection and accounts for growth. The discount rate roughly equals the cap rate plus the expected annual growth rate of cash flow.
Why does the discount rate matter so much? The discount rate matters because small changes in it swing the valuation by large amounts, especially for distant cash flows like the sale proceeds. It also encodes the investor's view on risk, so identical cash flows can produce different values through the rate chosen.
Related Terms
Net Present Value
Internal Rate of Return
Capitalization Rate
Time Value of Money