Discount Rates in Property Valuation: WACC, Build-Up, and Market Extraction

Book: Commercial Property Valuation: Methods and Case Studies
Authors: Giacomo Morri, Paolo Benedetto
ISBN: 9781119512127 (hardback), 9781119512134 (ePDF), 9781119512158 (ePub)

Cap rates you can often pull from deals. Discount rates you usually have to build. Chapter 7 part two is the practical half: what a discount rate is, how it links to WACC, and the main techniques European valuers use to estimate property return rates.

What is a discount rate?

The discount rate makes future cash flows comparable to today. It is the return investors require from an investment with similar risk. In plain terms: it is the expected IRR.

For market value:

• Use pre-tax operating cash flows (gross of tax, gross of financing)
• Use a market WACC (not one buyer’s leverage or tax position)

For investment value, you can go after-tax, levered, buyer-specific. Market value cannot.

Nominal flows with nominal rates is standard practice. Rents and costs often inflate. Investors think in nominal returns. Just stay consistent.

Keep the rate matched to the cash flow

Three traps to avoid:

1. Financing and tax: Market value uses gross cash flows and a market WACC. Do not discount NOI at an equity IRR unless flows are post-debt.
2. Lease risk: Secure leases are less risky than post-expiry re-letting at ERV. Theory splits intra-lease and inter-lease rates. Practice uses one blended rate. Do not double-count risk already baked into your cash flows.
3. Yield curve: Different maturities should use different risk-free rates. One rate for the whole horizon is the usual shortcut.

WACC: the discount rate building block

Discount rate for FCFO (free cash flow to operations) is usually WACC:

WACC = (Kd × D%) + (Ke × E%)

Where:

• Kd = cost of debt
• Ke = cost of equity
• D% / E% = market-value weights of debt and equity

Financial structure depends on timing, asset type, and tenant quality. Stabilised income assets carry more debt than development. Speculative projects may be all equity.

Cost of debt (Kd) = base rate + bank margin. Base rate comes from the fixed swap curve matched to your horizon. Margin from bank quotes. Example 7.5: Kd 5%, Ke 15%, 30% debt → WACC 12%.

Cost of equity (Ke) = risk-free rate + risk premium. Always above Kd. Built from judgment because every building is unique.

Four methods that matter in practice

1. Market extraction (cap rates): Income / price from recent comps. Same NOI definition, similar location, leases, and condition. Example 7.6: four CBD offices yield 6.90% to 7.34%, average 7.11%.
2. Cap rate + growth (discount rates): k ≈ cap rate + expected growth.
3. Build-up approach (mainly discount rates): Risk-free rate plus risk premiums in basis points.
4. Market surveys: CBRE, JLL, investor interviews as benchmarks.

Ellwood and Akerson formulas are obsolete. Skip them.

From cap rate to discount rate

You cannot observe IRR from a single sale. You only see yield. But yield and total return link through expected growth.

From the Gordon model: Value = Income / (k − g)

Rearranged: k ≈ cap rate + g

Example 7.7: 6% cap rate, 2% expected income growth → 8% discount rate. DCF and direct cap give the same value (~€1,667 on €100 income).

Rules:

• Match income level (NOI to NOI, not gross rent to net cash flow)
• Inflation as growth proxy works long-term, fails in downturns when ERV falls

Example 7.8 hammers the point. Two assets, same risk, same 9% IRR required. Asset A: flat cash flows, 9% initial yield, value €1,111. Asset B: 2% growth, 7% initial yield, value €1,429. Same risk. Different yield. Different price. Investors buy total return, not yield alone.

Build-up approach

Identify risk factors. Quantify each in basis points. Add to risk-free rate.

Property Return Rate = Risk-free rate + Σ risk premiums

For discount rate via WACC, build Ke with premiums for:

• Property sector risk
• Location risk
• Use/type risk
• Physical/technical risk
• Rental/contractual risk

Example 7.9 (income-producing property, 10-year horizon):

• Financial structure: 70% debt, 30% equity
• Kd: 1% swap + 3% spread = 4%
• Ke: 1.8% gov bond + 7.5% risk premiums = 9.3%
• WACC = 4% × 70% + 9.3% × 30% = 5.59%

Is 5.59% “correct”? That depends on whether you agree with each premium. The method’s value is forcing you to show your work.

The build-up forces you to show your work. The risk is tweaking basis points until the DCF lands where you want. Huge adjustments on weak comps mean you picked the wrong comps.

The honesty check

Rates are where valuations go to die quietly. Cash flows get paragraphs. The discount rate gets one line.

Before you sign off: Can you defend the cap rate from trades? Does discount rate ≈ cap rate + growth? Does leverage match the asset class? Did you double-count risk?

What is next in the series

Chapter 7 closes the theory block on methods and rates. From here the book shifts to case studies: offices, retail, hotels, and development projects with full Excel models on cpv-mb.com.

If you have followed the series from Chapter 4 through 7, you now have the full toolkit: pick the method, build the income, set the rate, and know when to admit the market will not give you a clean answer.

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