Cap rate - Discount Rates - Growth Rate for REITS

[Rasec]

I’m consufed about what to use.
In one problem they give you the “Going-in Cap rate”
and in another problem, they give you the ” Cap rate and growth rate”
when valuing real estate investments. I know the Terminal value should be discounted by (R -g) –> cap rate or going in cap rate?
but when using a P/AFFO multiples they used the Discount rate to discount the terminal value —>
Discount rate = cap rate + growth rate
SO CONFUSED!

 

[lammy]

RASEC! You’re racing through these topics so quickly - every day you’re onto another one! - you’re making me feel bad that I’m still trying to slog my way through quant. I’m so bloody toast.

 

[Rasec]

Lammy!
I almost fainted the other day walking to lunch!
I hate this so much

 

[Rasec]

S2000magician

- can you help me out with this one?

 

[S2000magician]

Rasec wrote:I’m consufed about what to use.
In one problem they give you the “Going-in Cap rate”
and in another problem, they give you the ” Cap rate and growth rate”
when valuing real estate investments. I know the Terminal value should be discounted by (R -g) –> cap rate or going in cap rate?
but when using a P/AFFO multiples they used the Discount rate to discount the terminal value —>
Discount rate = cap rate + growth rate
SO CONFUSED!

It’s all about Gordon growth.
Cap rate = discount rate − growth rate, by definition. Thus, discount rate = cap rate + growth rate.
The going-in cap rate is used, well, going in; for the terminal value, you will use the terminal cap rate (which is likely different). If they give you “going-in cap rate” and “cap rate”, I’d assume that the latter is the terminal cap rate; what else could it be?

 

[Rasec]

Here is the question:
REOC:
Expected AFFO in Yr 8 = 13.5M
Holding Period = 7 years
PV of all dividends for 7 years = 39.7
Cap rate = 7%
Growth = 2.5%
Price to AFFO = 12x
My logic here was:

• Get terminal value : 13.5 x 12 = 162 –. terminal value in Yr8.
• Discount back to Yr 7 using the your normal (Re - g). Using your statement above Cap rate = discount rate − growth rate; 7 = x - 2.5; Re=9.5.
• *** In my mind, the Cap rate is the rate to discount the terminal value
• 162 / .07 = 2314.28 value at time 7.
• discount 2314.28/ (1.095)^7 = 1126.07
• 1126 + 39.7 =1265.0 ~~ 126.5 ***WRONG***

Here is what the answer in the vigenette said:

• Terminal value estimate = 12 x 13.5 = 162 for the end of year 7
• The discount rate is the Cap rate + Growth rate = 9.5% **this counting the terminal value at the Cost of Equity, instead of the Re - G or cap rate….WHYYYYYY??? OH GOD WHYYY??? ****
• Discounting this terminal value to find the Present value: FV =162; N=7, I=9.5%; PV =85.83
• add the PV of dividends = 85.83 + 39.7 = 125.53

 

[S2000magician]

Rasec wrote:Here is the question:
REOC:
Expected AFFO in Yr 8 = 13.5M
Holding Period = 7 years
PV of all dividends for 7 years = 39.7
Cap rate = 7%
Growth = 2.5%
Price to AFFO = 12x
My logic here was:

• Get terminal value : 13.5 x 12 = 162 –. terminal value in Yr8.
• Discount back to Yr 7 using the your normal (Re - g). Using your statement above Cap rate = discount rate − growth rate; 7 = x - 2.5; Re=9.5.
• *** In my mind, the Cap rate is the rate to discount the terminal value
• 162 / .07 = 113.4 value at time 7.
• discount 162 / (1.095)^7 = 85.825
• 85.825 + 39.7 =125.525

hahahaha! I got the question right!!!!
I guess I had a mental break down when taking the mock
Thanks your your help

I don’t understand the bold, italic part, but the rest is obviously correct.
You’re getting this stuff! Good for you!

 

[Rasec]

S2000magician

I’m going crazy! I thought I had it…but I looked at my answer and it was wrong!

Please look at my revised post.

My logic is OFF

“crying inside”

 

[Rasec]

In a previous problems they divide the terminal value by (re-g) or what I call the cap rate
Problem: Expected NOI 1-7 = 7M
Expected NOI year 8.5
Required return on equity investment = 10%
NOI growth rate after 8 years
This was easy to calculate was your normal GGM.

• here the terminal value is discounted at Re-g
• and the cash flows are discounted at 10%

****I THINK MY ERROR IS THAT WHEN GIVEN A MULTIPLE HERE IS NO NEED TO DISCOUNT BY (Re-g) as that is the terminal value.****

 

[S2000magician]

You’re correct: you don’t divide the terminal value by (re − g), you divide the terminal cash flow by (re − g) to get terminal value.