Why Are We Still Stuck on Cap Rates? Discounted Cash Flow Analysis is Far Superior (and Here's Why)

Greetings, CRE colleagues and my current students! It’s The CRE Professor here, ready to tackle one of the industry's most stubborn habits—our ongoing love affair with the cap rate. Cap rates have their uses, sure, but is it time we ditch the “easy way” and elevate our approach with the far superior Discounted Cash Flow (DCF) analysis?

The Comfort of Cap Rates

The simple answer to “Why do we stick with cap rates?” is just that—it’s easy! When I started out, everything was calculated on a quick cap rate or, even worse, a simple payback period. You could practically do it in your head without so much as a calculator. But today’s market is more complex, and our analysis needs to keep pace.

So, why does DCF trump cap rates? For one, DCF goes far beyond the narrow one-year view of a cap rate, giving us a full picture of value over an asset’s entire holding period. Cap rates offer quick insights, but they miss the dynamics of cash flow over time, which is often where real value (or risk) lies.

What Exactly is a Cap Rate?

Let’s break it down for my students following along. A cap rate is essentially the percentage return an investor might expect on an all-cash purchase—in just the next year. It’s calculated by dividing the Net Operating Income (NOI) by the property’s purchase price.

Cap rates can serve as a quick comparison tool across properties, showing us market trends or investment patterns within regions or asset classes. But if you’re truly sizing up an investment, cap rates are like using a flashlight when you could be using high-beam headlights. They’re static and assume a straight line of growth (or no growth!), which rarely aligns with reality.

DCF Analysis: Because Cash Flow is King

This is where Discounted Cash Flow (DCF) analysis shines. It lets us take the whole cash flow model into account over the entire holding period, considering the anticipated timing, amount, and risk of future cash flows.

Here’s a quick overview of why DCF analysis should be your go-to:

1. Future Cash Flow Matters: Unlike cap rates, DCF digs into the anticipated stream of cash flow over time, not just next year’s snapshot.
2. Time Value of Money (TVM): One dollar today is worth more than a dollar next year due to opportunity costs, inflation, and risk. Cap rates don’t adjust for this, but DCF does, bringing future cash flows into present value.
3. Risk and Opportunity: DCF allows for a nuanced risk assessment by factoring in alternative investment opportunities and the investor’s risk tolerance.
4. Tools for Measurement: With DCF, you can use metrics like Net Present Value (NPV) and Internal Rate of Return (IRR), which provide a clearer picture of the property’s value in today’s dollars and its projected yield.

Key DCF Tools: NPV and IRR

For those less familiar, let’s look at these two power tools:

• Net Present Value (NPV): By subtracting the initial equity investment from the present value of future cash flows, NPV tells you if a property’s worth is greater than its cost. A positive NPV? The deal’s got potential. A negative NPV? Move on or renegotiate.
• Internal Rate of Return (IRR): IRR is the annual rate of return you’ll make on each invested dollar for each period it’s held. It gives a percentage that makes it easy to compare with other investment options, factoring in time, cash flow size, and risk.

Cap Rate vs. DCF—Why Not Use Both?

Don’t get me wrong—cap rates have their place! They’re handy for fast comparisons and as a rule of thumb. But think of cap rates as the starter kit, not the whole toolbox. When a property truly interests you, DCF analysis is essential to see if it will hold its own (or outperform) over time.

Making the Transition Easier

Not sure where to start with DCF? It’s easier than ever these days. Excel has ready-made templates for calculating NPV and IRR. So yes, you’ll need to move beyond mental math or quick calculations, but the rewards are worth it—trust me, your clients will notice the difference!

So, What’s the Bottom Line?

As much as I’d love for cap rates to be the “easy button” forever, today’s market complexity demands a more robust analysis. So the next time you’re tempted to make an investment decision based solely on a cap rate, consider DCF instead. You might be surprised how much deeper your understanding—and your returns—can go.

Stay savvy out there, and remember: easy is nice, but smart is better!

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Shawn Massey is an adjunct professor at The University of Memphis where he teaches a graduate class in real estate development and undergraduate/graduate in real estate investment. When he is not teaching, he is a full-time retail real estate advisor with TSCG. He holds the following designations CCIM, ALC through the National Association of Realtors and CRRP, CLS, SCLS designations through ICSC. To contact Shawn Massey please call (901) 461-7070 or via email at [email protected]