Thinking about pulling the trigger on a new commercial property?
Two anchor metrics in CRE — the cost of capital and the discount rate — can go a long way in helping you measure the CRE deal’s profitability.
These numbers are closely related but work differently, and understanding how to use each one will allow you to determine if a project’s returns will justify the risk and the money you’re putting in.
What does cost of capital mean in commercial real estate?
Every commercial real estate project needs funding, and that funding usually comes from two places: debt (like loans) and equity (money from investors or the developer).
Both lenders and investors expect something in return.
Lenders charge interest, while equity investors expect a share of the profits or an increase in the property’s value to compensate for the capital they’ve tied up in the project.
The cost of capital is the combined return all those parties expect, which essentially tells you the minimum rate of return your project needs to generate to cover the cost of financing.
Because most deals use a mix of debt and equity, you can’t just look at their costs separately — you also have to calculate a weighted average cost of capital or WACC to get one blended rate showing how much of each funding source you’re using.
How is WACC calculated in commercial real estate?
The formula for weighted average cost of capital (WACC) looks like this.
In plain terms, you multiply the percentage of financing that comes from equity by its expected return, then add the percentage from debt multiplied by its interest rate (adjusted for taxes). The result is your project’s WACC.
If your project’s expected return doesn’t exceed this number, then it is not generating enough value to satisfy both your lenders and investors.
Let’s look at some more examples of how you can use WACC to set the return threshold your project needs to beat:
Industrial redevelopment
You want to acquire an outdated warehouse and convert it into a modern logistics space.
You intend to finance the project with 50% debt at 8% and 50% equity, seeking 15%.
The WACC, when you apply the formula, is 11.5%. This means that you need an IRR of at least 13% to 14% to make the numbers work.
Office repositioning
You want to tackle a suburban office-to-flex conversion during a weak leasing market and plan to use 65% debt at 7.5% and 35% equity at 18%. The WACC will come down to about 11.2% in this case.
But if rents don’t rise as quickly as projected — or if it takes longer to lease up the space — your project’s cash flow could fall short.
That would pull the IRR below 11.2%, meaning the returns wouldn’t be enough to justify the capital invested.
This is why underwriting needs to include sensitivity tests that show how delays or weaker income affect your project’s bottom line.
What is the IRR-WACC spread, and why does it matter?
Institutional investors typically want a 200– to 300-basis point spread between IRR and WACC to protect against volatility and unexpected costs. Why this spread?
Because that margin helps absorb unexpected cost overruns or slower lease-up. If your projected IRR only exceeds the WACC by 50 to 100 basis points, there’s very little room for error.
Even a modest delay or drop in income can wipe out that spread entirely and leave the project underperforming.
What does discount rate mean in commercial real estate?
The discount rate is another classic metric you can use in commercial property valuation because it helps you figure out how much a stream of future income is worth today.
In discounted cash flow or DCF analysis, the idea is that a property’s value equals the present value of all the future cash flows it’s expected to generate, discounted using a rate that reflects both the time value of money and investment risk.
How does the DCF model work in commercial real estate?
To run a DCF model, you need three things:
- Projected cash flows pulled from the pro forma, which outlines expected rental income and operating expenses over the holding period. The difference between the two gives you the net operating income or NOI.
- A discount rate selected by the analyst, usually based on WACC plus a risk premium, depending on the asset and market conditions.
- A holding period that’s typically 5 to 10 years, based on how long you plan to keep the property.
Using these inputs, you can calculate the present value of each year’s projected NOI — and the property’s expected sale proceeds — using the formula:
PV = CF ÷ (1 + r) ^ t
Where:
- PV = present value
- CF = cash flow in year t
- r = discount rate
- t = number of years in the future
The net present value (NPV) of the property is the sum of all those discounted cash flows.
Don’t worry because you don’t need to do this manually.
You can use spreadsheet functions in Excel or Google Sheets to handle the math for you. Just enter the discount rate, the projected cash flows, and the number of periods.
Suppose you expect to earn $1 million in year 10, and your discount rate is 8%. The present value of that future cash flow is:
PV = $1,000,000 ÷ (1 + 0.08)^10
PV = $1,000,000 ÷ (2.1589)
PV ≈ $463,193
So even though you’ll receive $1 million in the future, it’s only worth about $463,000 today once you factor in time and risk.
Why does the discount rate matter in commercial real estate?
The higher the discount rate, the less the property’s future income is worth today.
So, if a Commercial property deal involves more risk — like in the case of a new construction or if you’re trying to turn around a struggling property — analysts might use a higher discount rate to account for that uncertainty.
But if the property is already leased and in a strong location, they might use a lower rate because the income is more predictable.
Analysts often start with the WACC as a base and then add a risk premium (usually 1% to 3%) to reflect uncertainties that may be specific to the project.
How do you test assumptions with the DCF model?
The discount rate lets you stress-test the deal under changing CRE market conditions and quantify how sensitive your project’s returns might be to changes in rent, cap rates, or expenses.
For example:
- What if rent grows at 2% annually instead of 4%?
- How would a 50-basis-point bump in your exit cap rate affect the sale price?
- What happens to your IRR if lease-up takes six months longer than planned?
With a strong DCF model, you can make sure that the numbers hold up beyond the pro forma.
Why is cost of capital and discount rate important in your underwriting?
These two numbers are critical because they let you weigh projected returns against financing costs and risk, ultimately showing whether the deal holds up under real-world conditions.
- The cost of capital shows how much it costs to fund your project. It combines the price of debt (the interest you pay to lenders) and the expected return demanded by equity investors. Together, these add up to the minimum return on your investment must earn to satisfy lenders and investors.
- Then, the discount rate tells you what that money is worth once it’s tied up in a project, factoring in time (how long it will be tied up), risk (the uncertainty of future cash flows), and opportunity cost (what you’re giving up by not putting it into a safer or more liquid investment).
If your projected IRR doesn’t exceed your cost of capital, the deal won’t generate enough profit to justify the risk you’re taking on, even if the top-line profit looks strong.
How do market conditions affect cost of capital and discount rate in commercial real estate?
Both your cost of capital and your discount rate will respond directly to macroeconomic shifts, often at the same time and in the same direction.
Interest rates and debt costs
When central banks raise interest rates, debt becomes more expensive, which increases your cost of capital because the debt component of your capital stack now demands more in interest payments.
Even a 1% rise in interest rates can sharply reduce your project’s profitability if it’s heavily financed with debt.
At the same time, rising rates typically raise the discount rate. Why?
Because investors adjust their return expectations upward to reflect a higher risk-free rate and tighter credit conditions.
That higher discount rate reduces the present value of your property’s future cash flows, therefore lowering your property’s valuation.
This chain reaction is why cap rates tend to rise when interest rates go up. Borrowing gets more expensive, so investors become more cautious and start demanding higher returns to take on the added risk.
Inflation’s double-edged impact
Inflation can help and hurt real estate underwriting at the same time.
For example, if nominal rents go up, your income projections might look stronger on paper.
But when inflation is high, the real value of that future income — what it’s actually worth in today’s terms — actually shrinks. So even if rents rise, lenders may still demand higher returns to protect their purchasing power. This will drive up the discount rate and, in many cases, the cost of equity, too.
Neither number is fixed
Your WACC and discount rate will always shift with the market, and if you don’t adjust your underwriting accordingly, you risk overpaying for deals that no longer pencil out under new market realities.
That’s why you need a CRE financing partner that can build flexible capital stacks that reflect today’s numbers instead of last quarter’s. Call Private Capital Investors at 972-865-6206 or tell us about your project here.
