Capitalization rate and discount rate as rates of return Capitalization rate

A frequently used method of estimating capitalization rate is based on market data, as a quotient of net operating income (NOI) possible to receive on the market and transaction price of real estate:

Capitalization rate is defined as a market rate of return for similar real estates in a selected real estate market segment in definite time. It is determined on the basis of many transactions entered on the market excluding the prices that deviate from the most common ones.

Furthermore, the capitalization rate applied in the valuation of real estate should be adjusted in case there is a difference between the real estate subject to valuation and real estates used as bases for calculating the market capitalization rate. The capitalization rate applied in the valuation process should reflect income risk from the subject real estate.

The capitalization rate calculated on the basis of market data defines rate of return for a particular real estate market segment.

29 Discount rate

Discount rate should:

- reflect investor’s expected rate of return on the capital market,

- reflect the risk rate desired by the investors in a particular market segment. The discount rate does not have to involve the risk of changes in rental fees, as well as the final (residual) value of a property, which are expressed in a real estate valuation formula.

The preferable way of calculating discount rate (r), is the correction of market capitalization rates, taking into consideration the expected changes of income earned by a property and the possible changes in property prices after the forecast period. While calculating the rate, one needs to take into consideration the difference between the risk rate related to earning income flows from the valued property, and the one related to properties for which market capitalization rates have been calculated. The risk related to earning a particular income may stem from the differences in:

location of a property, technical condition, functional standard,

terms and conditions of the contracts entered, tenants’ credibility,

other.

If it is not possible to calculate discount rate by the correction of market capitalization rates (lack of transactions in similar properties on the subject market), it may be estimated on the basis of capital market, with the application of market rates of return from risk-free investments, corrected by the system and risk premium¹⁶. While calculating discount rate, the following factors need to be taken into consideration:

average rentability of government bonds with a maturity period longer than a year, inflation rate (as the income is expressed as a real value),

systematic risk premium (the risk may be caused by crisis, inflation rise, changes in law and regulations, increase in rentability of other types of deposits),

specific risk premium (it is a bonus related to investing in a particular real estate market segment in the area).

Both capitalization and discount rate are the rates of return from real estates.

While discount rate reflects the return on invested capital, capitalization rate shows the relation of the annual income from the real estate to the price or value of the real estate. The two rates cannot be considered equivalent, as their economical interpretations are different.

If the valued real estate has potential to increase in value, the capitalization rate (R) will be lower than the discount rate (r) applied in the process of discounting cash flows in the forecast period. In case the income flow and the value show the downward tendency, the capitalization rate will be higher than the discount rate.

Valuing real estates by means of income approach means calculating market value of the right to receive cash flows for an indefinite period of time. To provide accuracy of calculation, it is crucial to properly assess market rent rates, capitalization rates, discount rates and other measures describing real estate market segment represented by the subject property.

On calculating the value of real estate it is necessary to exercise commensurability of rates of return and income rates. The capitalization rate ranks among income rates of return reflects the relation between the current annual income from real estate and its price or value. The capitalization rate enables the valuer to convert income into value of real estate [Ling and Archer 2005, p.202). Calculating capitalization rates on the basis of market transactions with similar real estates, various income types generated by real estates can be taken into account.

Thus:

16 Real estate investment risk has been thoroughly discussed in: P.J. Rowland [1993, p.178].

30 - if the effective gross income (EGI) was applied when determining capitalization rates for similar real estates subject to transactions, it must also be applied when valuing the subject real estate, i.e.

MV – market value of the real estate, RG – gross capitalization rate

- if the net operating income (NOI) was applied when determining capitalization rates for similar real estates, it should also be applied when valuing the subject real estate, i.e.

:

31 MV – market value of the real estate,

RN – net capitalization rate calculated on the basis of transactions with similar real estates by means of net operating income (NOI).

The described real estate valuation procedures employing profit method are presented in two case studies, i.e. a petrol station (1) and a hotel (2).

1.2.5. Valuation of a real estate developed with petrol station facilities – case study 1