LOS a: Explain the relation between a real estate capitalization rate and a discount rate.

The capitalization rate (C) is the rate of return that equity investors require on similar-risk real estate investments (k) net of the expected constant growth rate of net operating income (g). That is, C = k - g.

Where:

MV = estimated market value

NOI = the net operating income from a real estate investment.

k = the rate that equity investors require from a real estate investment.

g = the growth rate of NOI (assumed to be constant).

C = k – g = the market capitalization rate.

From this relationship, we see that: 

• as the growth rate of NOI increases, capitalization rates decline and value estimates will rise,
• the capitalization rate is the spread between k and g. Thus, as the spread widens, value estimates decline, and
• holding k constant, value is directly related to g.

The effect of inflation on value estimates depends on its combined effect on the required return (k) and the growth rate (g). If the net result is to decrease (increase) the capitalization rate, value estimates will rise (fall).

Where:

MV = estimated market value

NOI = the net operating income from a real estate investment.

k = the rate that equity investors require from a real estate investment.

g = the growth rate of NOI (assumed to be constant).

C = k – g = the market capitalization rate.

As the riskiness of a real estate investment increases, the uncertainty of its future cash flows increases. This has the effect of increasing investors’ required return (k) and increasing the capitalization rate. As cap rates rise, values decline.