Cap Rate vs Discount Rate: How They Differ and When to Use Each
By Devon Coombs, CPA, MBA · Assistant Teaching Professor of Finance, Santa Clara University · Reviewed October 2026
From the author: Devon Coombs, CPA, MBA teaches finance at Santa Clara University and works with corporate teams on practical AI.
Finance questions & answers · Student career guide · AI training for finance teams · Consulting · The 10 Laws of Finance
Use a cap rate to relate one year of NOI to property value. Use a discount rate to bring future cash flows to present value. The shortcut cap rate = discount rate − growth applies to a constant-growth perpetuity with consistent cash-flow definitions. A property's market NOI cap rate is not automatically its discount rate less rent growth.
| Cap rate | Discount rate | |
|---|---|---|
| Definition | Year-one NOI divided by value | Required total return used to discount future cash flows |
| Applies to | A single representative year | Every projected cash flow, including the reversion |
| Growth | Embedded implicitly; expected growth compresses it | Handled explicitly in the projected cash flows |
| Source | Extracted from comparable sales | Risk-free rate plus risk premia, or investor surveys |
| Relationship | Equals discount rate minus growth only under matching constant-growth perpetuity assumptions | Reflects the risk of the cash-flow stream being discounted |
| What to check | NOI period, capital needs, lease terms and comparable-sale assumptions | Cash-flow timing, growth, sale proceeds and the chosen financing perspective |
When Cap rate is the right tool
Direct capitalization can be useful when a representative year of stabilized NOI and suitable market comparables support the estimate. Check whether the stated cap rate uses trailing or forward NOI and consistent expense assumptions. Expected growth, tenant risk, lease terms and future capital requirements can all influence the market cap rate.
When Discount rate is the right tool
Use a DCF when timing matters: lease expirations, renovation costs, vacancy, rent changes or a planned sale. Forecast the relevant cash flows and discount them at a rate appropriate to their risk. Discount property cash flows using a property-level rate and equity cash flows using an equity rate. A higher rate lowers present value if positive future cash flows are otherwise unchanged.
The common mistake
Treating the spread between any observed cap rate and discount rate as a pure growth forecast. That shortcut can fail when NOI differs from distributable cash flow, capital spending matters, growth changes over time, or the model has a finite holding period. Reconcile the full cash flows before drawing a conclusion.
Where the 7%, 10% and 3% relationship comes from
- $70,000 of next-year cash flow growing 3% forever, discounted at 10%, has a perpetuity value of $70,000 ÷ (10% − 3%) = $1,000,000.
- If NOI is also $70,000 under those same simplified assumptions, NOI ÷ value is 7%.
- Now add a roof replacement, leasing costs or uneven rent changes. Build those cash flows into the model; do not assume the same shortcut still prices the property correctly.
This is a teaching illustration, not a property valuation. The formula requires the discount rate to exceed the perpetual growth rate and both rates to use the same period.
Related question: Can a vacant building be worth more than a fully leased one?
References & further reading
Work the numbers yourself
Both concepts are taught in depth, with practice questions, in the free Real Estate Finance course.