When it comes to commercial real estate, the cap rate comes up in just about every discussion. There’s good reason for this, considering it’s a way for investors to figure out if the investment is a good choice or a bad choice. While the cap rate is important, it should not be the only consideration when it comes to making an investment choice.
In order to estimate your potential cap rate, take your estimated net operating income and divide it into your current market value. The results allows the investor to estimate their potential return on their investment. Direct capitalization is a great process in a stable marketplace; however, it fails to reflect changes in market conditions, and it does not take into account for any financial leverage benefits or any income changes.
Going from Cap Rate to Discounted Cash Flow
Due to the shortcomings of the cap rate, many commercial real estate investors will use the discounted cash flow “DCF” analysis when making decisions. This is a more advanced option and looks at the time value of money. Discounting is a bit like the opposite of compounding and this formula will show a more accurate look at what the future may bring.
When using the DCF method, an investor will actually calculate the Net Present Value and the Internal Rate of Return. These two metrics provides more insight than simply using a cap rate calculation. By using the discounted cash flow analysis, an investor will actually see the difference between a dollar today and a dollar in the future. Many things can change in just a few years and it’s important to take everything into consideration, which the cap rate method doesn’t do.
Not only is the DCF analysis used for commercial real estate investments, but it’s also used throughout financial transactions of all types. Discounting is necessary because of inflation and how the value of money changes over time. While this is a bit of a simple explanation of the DCF analysis as complete courts have been taught on the subject, it’s used to show why this method may be preferred over the cap rate method when investing in commercial real estate.
Using a cap rate calculation may seem like a good idea when investing in commercial real estate. However, a discount cash flow analysis will actually give an investor a better view of the Net Present Value and the Internal Rate of Return. When making any investment decision, it’s important to know what the numbers are telling you and knowing their shortcomings. Make sure to look at the full picture and not just one calculation.