The discount rate is the rate used to discount to net present value a stream of CRE cash flows over some time period, usually five, seven or 10 years. The stream of cash flows can be either the net operating income, net operating income after tenant improvements, leasing commission and capital improvements or net cash flow to the equity investor.

The discount rate is determined from the first part of the cap rate formula as the risk free rate plus the risk premium and in the example above, would be 2.25% + 7% or 9.25%. The growth rate is not deducted as in the cap rate formula because the discount rate is applied to a series of cash flows and not a one year cash flow. The discount rate is then used to discount the yearly cash flows and the terminal value of the property, which is determined by applying the cap rate to the next year's cash flow. The discount rate will always be higher than the cap rate as long as income growth is positive.

Many public REITs use the above calculations to determine their cap rate and discount rate. However, since they are public companies with secured and unsecured debt, preferred stock and common stock, they can also determine a discount rate by calculating their weighted average cost of capital (WACC) as deliberated in corporate finance. The WACC is the weighted average cost of the REITs, long term debt plus preferred stock, if any, and common stock. The cost of debt is the yield on the debt times its weight in the capital structure and excludes the tax effect because REITs are not subject to income tax. The cost of preferred stock is the dividend divided by the price and the cost of common stock is determined by the capital asset pricing model (CAPM).

The CAPM is risk-free rate plus the stocks beta times the sum of the market return less the risk free rate. Most of the large-capitalization REITs have WACCs of 8%-11%.