A good question.
Here are my thoughts:
A property purchaser’s discount rate represents their perceived opportunity cost in making one investment over another investment of comparable characteristics, including valuation, risk profile and timeline.
Assuming an all-cash purchase of a property, the purchaser’s going-in cap rate (defined as Year 1 Adjusted NOI/Purchase Price) is in essence their revelation of their Year 1 discount rate for the investment.
Assuming debt financing is used in purchasing the property, the going-in cash-on-cash return (defined as Year 1 net cash flow/total cash invested), which will be higher than the cap rate, is in essence the purchaser’s Year 1 discount rate for the investment.
As the purchaser holds the property and comes to know its cash flow characteristics better, and as tenancies change, the purchaser’s discount rate for each year could shift either up or down depending on the risk they perceive in that year, so the cap rate in those years does not any longer necessarily reflect the purchaser’s discount rate.
The cap rate is inextricably linked to the discount rate, the easiest way to define it is: cap rate = discount rate – growth rate. The quick and easy valuation of an investment through dividing the t1 NOI by the cap rate will be equivalent to the valuation of the same investment by discounting future NOI and a terminal value if growth and cf’s are held constant for all future values.
Hi Jake, thanks. Yes, you are correct. The assumption of constant growth is where it gets tricky, though.
Great post. I think the real trick is knowing how each NOI is calculated. What’s included and what is not, in some cases what was moved the balance or what was not.