Discounted Cash Flow (DCF)

Discounted cash flow values an asset by projecting its cash flows over a holding period, including the eventual sale, and discounting each back to today at a required rate of return. A cap rate is a compressed one-year version of the same idea: value equals next year's NOI divided by the discount rate minus growth.

DCF handles what a cap rate cannot: rents that change, expenses that grow at a different rate, a renovation in year two, a refinance in year three, and a sale at a different cap rate than the purchase. The output is a net present value or an internal rate of return.

The cost is assumptions. A DCF is only as good as its rent growth, expense growth and exit cap rate, none of which are known. Direct capitalization with a cap rate uses one observable year and one market-derived rate, which is why appraisers and buyers still lead with it. The two agree when NOI grows at a steady rate forever; they diverge whenever the future does not look like a scaled copy of this year.

Further reading: Discounted Cash Flow (DCF) on Wikipedia.