Cap Rate vs Discount Rate and IRR: One Year vs the Whole Hold

A cap rate is a one year number. A discount rate is the return you require on every year you own the place. IRR is what the whole hold actually paid, from the day you buy to the day you sell. That is cap rate vs discount rate and cap rate vs IRR in three sentences, and the gap between the first two has a name: growth.

Most buyers meet the cap rate first and read it as their expected return. Then a discounted cash flow or a broker’s IRR comes back much higher and it looks like someone made an error. Usually nobody did.

A cap rate is one year, a discount rate is every year

The cap rate is net operating income divided by price, for one year. Take the house this site uses as its standard example. It costs $500,000 and rents for $4,000 a month. At 5% vacancy you collect $45,600. Taxes run $6,000, insurance $2,500, and 18% of collected income, $8,208, covers maintenance, reserves and management. NOI is $28,892, so the cap rate is 5.78%. The simple version, $30,000 of NOI on $500,000, is 6%.

Notice what that calculation leaves out. No year two. No rent growth, no sale price, no loan. It is one kind of rate of return measured across a single year, which is why it compares properties so well and why it tells you nothing about the future.

A discount rate runs the other direction. It is the annual return you demand for taking this risk, applied to every future year. In a discounted cash flow you forecast NOI for each year of the hold, add a sale at the end, then shrink all those future dollars back to today at your rate. The cap rate is handed to you by the market. The discount rate is something you choose.

The link between them: discount rate minus growth

For a property whose income grows at a steady rate forever, the two are locked together:

cap rate = discount rate minus growth rate

Our house at a 5.78% cap rate is consistent with a buyer who wants 8.78% a year and expects NOI to grow 3% a year. Check it. $28,892 divided by (8.78% minus 3%) is $28,892 / 0.0578, which is $500,000.

Now cut expected growth to 2% and keep the same 8.78% requirement. Value drops to $28,892 / 0.0678, about $426,000, a 6.78% cap rate. One point less growth, one point more cap rate. That is the entire relationship. A low cap rate is not generosity from the seller, it is a growth forecast priced in.

It also settles the question people ask backwards: a cap rate is not a perpetual growth rate. It is a required return with perpetual growth already subtracted out of it.

Where IRR fits and why it wins on a value-add deal

Internal rate of return is the one annual rate that makes everything balance: the cash you put in, every year of cash flow, and the sale.

Hold the standard house ten years for cash, grow NOI 3% a year, and sell at the same 5.78% cap rate. Year eleven NOI is $38,829, so the terminal value is about $672,000. The IRR on those cash flows is 8.78%, the same as the discount rate above. Take 6% off the sale for costs and it lands nearer 8.4%. When growth is smooth and the exit cap matches the entry cap, IRR and discount rate converge, and the cap rate sits a full growth rate below both.

Value-add breaks that symmetry, which is where IRR earns its keep. Say you spend $25,000 on the kitchens and push rent from $4,000 to $4,400. Collected income becomes $50,160, the 18% allowance becomes $9,029, and NOI becomes $32,631. On $525,000 all in, that is a 6.21% cap rate, and at a 5.78% exit cap the property is worth about $564,550. During the year of the work, with units empty, your real one year cap rate is below 5.78%. Both one year readings understate the deal. Only the whole hold number sees the lift. The return on your own cash splits off in its own way once a loan is involved, which is the subject of cap rate against your own cash return.

The same property priced three ways

• As a cap rate: $28,892 on $500,000 is 5.78%. One year, no assumptions, nothing to argue about.
• As a DCF: demand 9% and expect 3% growth, and the same income is worth $28,892 / 0.06, about $481,500, a 6% cap rate. At $500,000 you are paying above your own hurdle.
• As an IRR: pay $500,000, get 3% growth and an exit at the entry cap, and the hold earned 8.78% a year before selling costs.

Three numbers, one building, none of them wrong. The price and value side of this gets its own treatment in the cap rate valuation guide.

Which to screen with and which to commit on

Screen with the cap rate. You can work it out from a listing in a minute, it makes a duplex in one town comparable to a fourplex in another, and brokers, appraisers and lenders all quote it. A property priced at a 4% cap rate on honest expenses in a market trading at 6% is expensive, and no forecast rescues it.

Commit on the discount rate and the IRR. Before you wire money, write down what return you need, what you think income will do, how long you will hold, and what exit cap rate you expect. The DCF turns those four guesses into a price you are willing to pay. The IRR turns them into one number you can set against your other choices.

Common mistakes when you mix the two

• Reading the cap rate as your return. It is the property’s first year yield at that price. Whether a cap rate is the same as ROI comes up constantly, and the answer is no.
• Counting growth twice. If your discount rate already sits a few points above the cap rate, the growth is in there. Adding rent increases on top inflates the value.
• Exiting at a lower cap rate than you entered. That assumes the market pays more for the same income later, which is a bet, not an assumption.
• Comparing an IRR that includes a mortgage to a cap rate that does not. Debt lifts the IRR and leaves the cap rate alone.

Start with the one year number

All three measures sit on top of honest NOI, so get that first. The Cap Rate Calculator on the home page takes rent, vacancy, taxes, insurance and the maintenance allowance and returns the NOI and cap rate for year one. Once that number holds up, add a growth rate to get your discount rate and a hold period to get an IRR.