Capitalisation Rates and Discount Rates explained

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October 21, 2022

In the world of commercial property valuation, it is 1). rental income streams, 2). annualized property expenses, 3). vacancies, 4). capitalization rates and 5). discount rates which all impact the Value of a property.  These are the essences of commercial property valuation where all of these elements together reflect risk, security and confidence in the asset being valued.

Items listed 1 to 3 above form the basis of determining Nett Annualised Rental Income which is then Capitalised at an appropriate rate to determine Present Value of an asset or property.

Capitalisation Rates and Discount Rates are two different concepts and are made up of similar, but also different elements.  The basic differences between a Cap Rate and a Discount Rate is that the former capitalises a net annualized income stream into present value, whereas the latter discounts a number of future income streams into present value.

Contrary to some views in the economy, there is no mathematical build-up of a Capitalisation Rate, these are determined from the yields against which properties transact at.  By way of example, if a property has a net annualised rental income of R 100K and it transacts at a value of R 1m, then the net annualized income is yielding 10% return on the deal.  In valuation practice, Valuers will research multiple comparable sales to establish a Yield Rate range upon which to base the selection of a capitalisation rate which is to be applied to the property being valued.  So, if market research indicates yield rates in a tight range of 8.5% to 9.5%, the Valuer will select a cap rate based on the strength of the property, type and length of covenant in place, quality of offering, nodal strengths together with Macro influences.  In essence then, Cap Rates are derived from arms-length sales yield transactions.

Discount Rates are another story, to an extent.  Traditional textbooks will say that a Discount Rate is made up of Cap Rate plus Lease Escalation Rate; in practice, this is Cap Rate plus smoothed market growth, not lease escalation.  An alternative approach to the establishment of a discount rate is termed the build-up approach. 

The build-up approach is based on the following elements:

  • Prevailing Long Bond rate which matches the income stream, eg. 10 year cashflow, R186 which has an investment horizon of 10 years or close to it – say 9.25%
  • Less: Income Contingency – risk based on annualized income receipt vs monthly income receipt – Standard is -0.25%
  • Add: Property Risk – Standard is 1.5%.
  • Add: Regional Factor – Standard is 1.5%.
  • Add: Sector Factor – Standard is 1%
  • Add: Tenant Risk Factor – Standard is 1%

Given the above, by way of calculation, this amounts to a Discount Rate of 14%.  As a cross check, we consider the Cap Rate plus smoothed market growth: Cap 9.5% + smoothed market growth 4.5% = Discount Rate of 14%.  The textbook method is not applicable any longer because it would penalize the value unnecessarily, eg. Cap Rate 9.5% + lease escalation 6.5% = 16%.

In the calculation of Discount Rates, the largely non-variable number is the long bond rate, whilst the Valuer is able to manipulate the other 5 variables in the matrix depending on the strength of the property, type and length of covenant/s in place, quality of offering, nodal strengths together with Macro influences.

What is detailed herein may look straight forward at a glance, however this is indeed far from the case.  Property Valuation entails a strong comprehension of mathematics, in-depth knowledge of local and international economies, in-depth knowledge of the business performances of tenants in occupation and a good “feel” for property, to mention but a few.  This is why the Valuation Profession is well equipped and educated in undertaking this type of work.  Chat with us, at Spectrum Valuations & Asset Solutions we have the teams to solution your property investment decisions.