When using the DCF method to value real estate, we calculate a terminal value using a terminal cap rate (so far so good), but then I’m lost: in some cases we use the discount rate to discount the terminal value back to present, and in some others we use the terminal cap rate (aka All risks yield) to discount the terminal value.
Can someone help me on this?
CAP rate is like a P/E multiple except it is reciprocated; at any given point in time, if you know the market value of a property (price) and the latest operating income (earnings) then cap rate is earnings/price. So it is a dynamic ratio that depends on how income and market valuation changes.
ARY is more like internal rate of return. It is a true discount rate. It is applied when the tenant pays all (most) operating expenses so the owner is left with a net cash flow that is the rent. So rent/ARY gives the value of the property as if the property were a perpetuity.
The highlight here is that CAP uses NOI in the numerator, while ARY uses rent. That’s all you have to remember for the exam.