RE5003 Chap.7 Discount Rates, Cap Rates and the Cost of Capital
Discount Rates, Cap Rates and the Cost of Capital
The rate is a decision
The lecture is explicit that choosing a discount rate is subjective and critical when choosing among opportunities. In the IRR approach, the investor must set a minimum acceptable return to compare against the estimate. Four methods are listed.
The summation technique adds compensations for deferring consumption, bearing risk, sacrificing liquidity and managing the asset, with the warning that more components mean more chances of error. The risk-adjusted rate adds one premium to a risk-free rate proxied by the short-term Treasury bill yield, and the lecture connects it to the capital asset pricing model.
The opportunity cost of capital is the return on the best alternative of similar risk. The marginal cost of capital is the weighted cost of new funds.
Weighted average cost of capital
When funds come from several sources, the weights come from the firm's capital structure, not from the project. The lecture's example weights a 6% cost of debt and a 12% equity return at 30% and 70%, giving 10.2%.
REIT investors expect new purchases to be yield accretive rather than dilutive, so a property yielding less than the REIT's cost of capital dilutes returns.
Capitalisation rates
A cap rate relates one year of net operating income to value.
The lecture asks what determines cap rates, how they are computed in practice, and whether single-tenant buildings should carry higher rates than multi-tenant ones, with implications for sale and leaseback.
It groups the sources of variation into fixed effects, such as lease terms, capital spending needs, size, tenant sensitivity, information costs, investor familiarity, substitutability and convertibility; shocks to capital markets such as interest rates and inflation; and persistence from capital requirements and information inefficiencies.
Garbage in, garbage out
The lecture closes the topic with the errors that hide inside discounted cash flow models: rent growth set too high, capital improvements and going-out cap rates projected too low, and a discount rate set wrongly.
The remedy is to read the detail, look for assumptions nobody stated, and test each against market evidence.
What this chapter covers
- 01
Why the choice of discount rate is subjective and critical
- 02
Summation, risk-adjusted, opportunity-cost and marginal-cost methods
- 03
Weighted average cost of capital and yield accretion
- 04
Capitalisation rates and their sensitivity
- 05
Sources of variation in cap rates, including single-tenant risk
- 06
Common errors hidden in discounted cash flow models
Worked example · free
Building a rate and testing a value
- 1Add the four compensations.
- 1Capitalise the income at 5.0%.
- 2Recompute at 5.5% and state the change.
Key terms
- Summation Technique
- Building a discount rate by adding separate compensations for waiting, risk, illiquidity and management.
- Risk Premium
- The return above the risk-free rate that compensates an investor for bearing risk.
- Risk-Free Rate
- Compensation for waiting with no default risk, usually proxied by a short-term Treasury bill yield.
- Cost of Capital
- The return required by the providers of funds, weighted across debt and equity.
- Yield Accretion
- A purchase whose yield exceeds the buyer's cost of capital, raising returns to existing investors.
- Capitalisation Rate
- One year of net operating income divided by value, used to turn income directly into value.
Discount Rates, Cap Rates and the Cost of Capital FAQ
Which method of setting a discount rate is best?
None is best in every case. Summation is transparent but error-prone as components multiply, the risk-adjusted rate depends on the investor's view of risk, opportunity cost needs a comparable alternative, and WACC reflects the firm rather than the project.
Why must WACC use the firm's capital structure rather than the project's?
Extra borrowing on one project raises the risk carried by equity across the whole firm. Using the project's own heavy debt mix to lower its hurdle makes a weak deal look stronger than it is.
What does yield accretive mean for a REIT?
A purchase is accretive when its yield exceeds the cost of the capital used to buy it, so returns to existing unitholders rise. A purchase yielding less than that cost is dilutive, however large it makes the portfolio.
Should a single-tenant building have a higher cap rate?
Usually, because income depends on one covenant and one lease expiry. A strong tenant on a long lease narrows the gap, which is how sale and leaseback deals are priced.
What are the most common mistakes in a DCF model?
The lecture lists rent growth set too high, capital improvements and going-out cap rates projected too low, and a discount rate set wrongly. Each flatters the result and, repeated, undermines trust in the method.
Assessment move
Set a rate by two methods for the same investor and explain the difference in a sentence. Then run every valuation at a cap rate half a point higher than your base case; if the decision flips, say so in the conclusion.
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