I spoke to a commercial real estate broker in reference to a NJ office property, and he told me that cap rates could be 200 basis points higher now than they were early 2022. However, he seemed to think that discount rates might not be much higher than they were. I am wondering what the reasoning behind this is, and if this is in fact true.
Thanks for any insight.
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Maybe I don't run in the same circles as others, but I haven't seen anyone use a discount rate to underwrite a real estate investment since I was in school. Everything I've seen is based on cap rates (NOI/cap_rate - total_cost = value_creation) or else IRR and equity multiple.
A discount rate is basically the same thing as target IRR or required rate of return. So for example, if you require an 8% unlevered IRR, you'll be willing to pay x dollars with a given cash flow discounted at 8%. Investors plug in a purchse price and see what the returns are - as an appraiser, I am plugging in a discount rate and seeing what the value is, so its just the inverse.
I understand the distinction. Just commenting on what's common practice among developers I've seen.
Logically, the discount rate/required IRR for a real estate investment should include a risk premium over the risk-free rate, and if the risk-free rate has increased-which it obviously has-then the discount rate should as well. The market doesn't necessarily react immediately but it should trend in that direction.
I suspect that there's a lot of cope going around at the moment...basic financial math indicates that the sharp increases in interest rates should sharply reduce property values, but actually doing that math is brutal for pro formas, so a lot of people are in wait-and-see mode.
But discount rate should flow into calculation of a cap rate. R-g. R being required rate of return or discount rate.
Not sure what you mean exactly. Cap rates and discount rates/IRR are different things. If you're only doing a direct cap of a single year's NOI then you wouldn't use discount rates, but if you are running a 10-year cash flow then you need to discount the cash flows to determine the NPV (which includes the exit value determined by the exit cap rate).
In real-world underwriting of RE investments, the cap rates are generally based on empirical observation rather than theoretical calculation. So the people creating the pro formas aren't thinking about discount rates in explicit terms.
My old firm (institutional Life Co) underwrote based on discount and cap rate, exclusively (for debt deals). Equity just solved to a purchase price. But we were constantly talking about the discount rate / IRR and risk premium we would need for the deal.
Forgive me but I absolutely hate these finance bros who have ruined real estate with these complicated financial terms. All of the successful owner/operator shops I know of have founders/leaders who barely know how to use excel smh…
Sounds like small-time local investors who don't understand how a basic cash flow works. A discount rate is literally one of the most basic concepts in commercial real estate valuation.
There are loads of people who've done big deals and made tons of money who fit the above description perfectly.
I think the argument the broker is making is just that the long term risk profile of the asset remains unchanged. If you zoom out and conceptually think about your ten year hold, your overall risk should be relatively similar today as it was 6 months ago. Typically, long term holds assume a return to the mean over time.
I guess he means levered discount rate, which is IRR. People are solving to basically the same IRRs as they used to, but since the cost of debt has increased, you need to buy at a higher cap rate to get the same levered return.
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