Property Return Rates and Cap Rates: What the Numbers Really Mean

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

You can nail the rent roll and still wreck the valuation with the wrong rate. Chapter 7 is where Morri and Benedetto slow down and explain what cap rates and discount rates actually represent. This post covers part one: measuring returns, the capital market framework, and cap rates in detail.

Two rates, one concept

Income capitalisation uses two rate types:

• Cap rate (direct capitalisation): links one year’s income to value
• Discount rate (DCF): links many future cash flows to present value

Both express what investors expect to earn. Both reflect risk in the income. The difference is timing and completeness. Cap rate ≈ current yield. Discount rate ≈ total return (IRR).

Getting rates wrong is one of the most common and least well-documented errors in valuation reports.

How property returns break down

Total return has two parts:

1. Yield (current return): income / price
2. Capital gain (growth return): price increase / initial price

Example 7.1: buy for €100, earn €6 income, sell for €110.

• Yield: 6%
• Growth: 10%
• Total return: 16%

Over multiple periods, you cannot just divide total return by years. Cash flows arrive at different times. Use IRR: the discount rate that makes net present value equal zero.

Example 7.3: buy for €100, receive rising income over five years, sell for €115 in year 5. IRR ≈ 13.77%. That is the proper total return. A simple average would lie.

Simple summary from the book:

• Cap rate ≈ expected current return (yield)
• Discount rate ≈ expected total return (IRR)
• The gap between them reflects expected income and value growth

Development vs income-producing assets

Extreme cases clarify the split:

• Development sold unleased: return is almost all capital gain (sale minus cost)
• Stabilised income property, flat rents, flat cap rates: return is almost all yield

Real projects sit between these poles. Developers minimise lease-up time before sale. Long-hold investors live on yield with some growth baked in.

Return expectations differ hugely between development and stabilised commercial. Risk is not the same. Neither should the rate be.

Rates and the capital market

Both cap and discount rates follow:

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

Risk-free rate

Compensation for deferring consumption with certainty. In practice, use a zero-coupon government bond matched to your valuation horizon (often 5 or 10 years).

Two risks to avoid in the “risk-free” label:

1. Default risk (use solid sovereign debt)
2. Reinvestment risk (coupons must be reinvested at unknown future rates; zero-coupon bonds avoid this)

Valuers often simplify with one bond yield for the whole horizon instead of a different rate per period. Usually acceptable when the yield curve is normal.

Risk premium

Extra return for taking property risk instead of holding government bonds. Can be measured:

• Ex-post: historical average property return minus risk-free (hard in real estate; limited data)
• Ex-ante: build up from risk factors and judgment (more common)

Premiums move with market sentiment, not just spreadsheets. Fundamentals matter. So does investor mood.

Cap rate defined

Appraisal Institute definition (paraphrased): an income rate that converts a single year’s expected NOI into an indication of total property value.

In practice, cap rate, overall cap rate, yield, and all risks yield get used interchangeably. Subtle difference:

• Yield = output (what the market traded at)
• Cap rate = input (what you apply in the valuation formula)

Two sides of the same coin.

Formula: Cap Rate = Income / Price

Going-in vs going-out cap rates

Going-in cap rate (GICR): income at valuation date / today’s price. Observable from recent sales.

Going-out cap rate (GOCR): income after your forecast horizon / terminal value. Not observable. Must be estimated.

GICR is what people mean when they say “the cap rate is 5.5%.” GOCR is what you need for DCF terminal values.

Why GOCR is usually higher than GICR

Valuers often add 25 to 75+ basis points (sometimes more) to GICR for GOCR. Reasons:

1. Future uncertainty = higher risk = higher rate
2. Building ageing: without major capex, the asset is older and less productive at exit
3. Wasting asset theory: buildings deteriorate; income capacity fades

Factors when setting GOCR spread:

• Length of forecast horizon (short horizon → small spread)
• Building age and capex plan (recent build with maintenance budget → smaller spread)
• Expected redevelopment potential (major upside can lower GOCR)
• Expected market shifts (rates, vacancy, supply/demand)

Example 7.4 shows how sensitive terminal value is. At 7% GICR on €70 income, value = €1,000. If GOCR drops to 6% with same income, terminal value jumps to €1,167. If GOCR rises to 8%, it falls to €875. Income growth at constant 7% cap rate moves value too. Small rate moves, big value swings.

What drives cap rates over time

Lower future cap rates (higher values) tend to follow unexpected demand growth or lower risk-free rates. Higher cap rates follow supply shocks or rising risk-free rates. Cap rates also track vacancy in the space market. Tight market → lower yields. Loose market → higher yields.

Why this chapter matters

Everything in Chapter 6 math depends on these rates. Value = NOI / cap rate. Present value = discounted cash flows. Terminal value = exit NOI / GOCR.

Income can be perfect. If your cap rate is a guess pulled from a broker’s slide deck with no link to comps or risk, your valuation is decoration.

Part two of Chapter 7 covers discount rates, WACC, and how to actually estimate these numbers in practice. That is the next post.

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