Discount Rates for Net Lease DCFs: A Practical Framework

TL;DR

Discount rates on commercial real estate DCFs aren't pulled from a magic lookup table — they're built up from three components: a risk-free rate (typically the 10-year US Treasury yield), an equity risk premium for commercial real estate as an asset class (historically 3-5% over the risk-free rate for core assets), and property-specific adjustments reflecting the credit, location, lease structure, and other factors that make a specific deal riskier or safer than the category average. For net lease investments, the total discount rate typically lands in the 7-11% range for stabilized core deals, with higher-risk or value-add deals running 11-15%+. Getting the number right is more important than getting it precise — but the build-up framework prevents ad hoc "what feels right" assumptions that produce valuations no one can defend.

Why Discount Rate Selection Matters

A discount rate is the rate at which future cash flows are discounted to present value in a DCF analysis. Two deals with identical projected cash flows but different discount rates produce different valuations — often materially different.

Rough sensitivity:

• A 100 basis point change in discount rate on a 10-year DCF typically changes the resulting valuation by 6-8%
• On a $10M target valuation, that's a $600K-$800K swing
• On cross-deal comparisons, discount rate inconsistency is a common source of apples-to-oranges pricing errors

The good news: the discount rate selection is systematic when you follow a framework rather than guessing.

The Build-Up Method

The most defensible approach to discount rate selection is the "build-up method" — assembling the rate from component layers, each of which is independently supportable.

Layer 1: Risk-Free Rate

Start with the 10-year U.S. Treasury yield (as of the valuation date, from Federal Reserve H.15 data).

This is the risk-free return for the currency, at a duration approximately matching the typical commercial real estate hold period. Use the actual current yield at the date of your valuation — not an average or a historical number.

In any market condition, the 10-year Treasury yield is a real, observable, current number — you don't estimate this.

Layer 2: Equity Risk Premium for Commercial Real Estate

Add an equity risk premium reflecting the additional return required to hold commercial real estate as an asset class rather than Treasuries.

Historically, the commercial real estate equity risk premium for core, stabilized, institutional-quality properties has run 3-5% above the risk-free rate — though this has varied with market conditions, capital flows, and general risk appetite.

Think of this layer as compensating for:

• Illiquidity (real estate isn't a ticker you can sell intraday)
• Leverage embedded in the asset class (most commercial real estate is levered, and even unlevered analysis captures this implicitly)
• Market valuation cyclicality (real estate values move with broader capital markets)
• Capital calls and operational management requirements

For 2026 valuations, a reasonable assumption for the CRE equity risk premium is 3-5% above the 10-year Treasury, landing total baseline CRE discount rate (Treasury + CRE equity risk premium) in the 6.5-8.5% range for core stabilized properties in most market conditions.

Layer 3: Property-Specific Adjustments

This is where the rubber meets the road on specific deals. Adjustments that tighten or widen the discount rate:

Tenant credit adjustment:

• Investment-grade credit, long remaining term: −25 to −100 bps from baseline
• Typical investment-grade or strong private company credit: 0 bps (baseline)
• Sub-investment-grade credit: +50 to +200 bps
• Unrated single-unit franchisee: +100 to +300 bps
• Significant tenant credit uncertainty: +200 to +500 bps

Lease structure adjustment:

• Absolute NNN with strong guaranty and long term: −25 bps
• Standard NNN lease with strong credit: 0 bps
• Double-net or modified gross with landlord exposure: +25 to +75 bps
• Unusual structure with material landlord risk: +100 to +300 bps

Location / market adjustment:

• Core-quality location in major metro: 0 bps
• Strong secondary market location: +25 to +75 bps
• Tertiary or rural location: +75 to +200 bps
• Challenged or declining market: +100 to +300 bps

Lease term adjustment:

• Long remaining term (15+ years): −25 bps
• Standard term (10-15 years): 0 bps
• Short term (5-10 years): +25 to +100 bps
• Very short term (<5 years): +100 to +400 bps (functionally a reversion-focused valuation)

Operating complexity:

• Pure net lease, minimal operations: 0 bps
• Limited landlord operations: +25 to +50 bps
• Meaningful operating complexity (percentage rent, CAM reconciliation complexity): +50 to +150 bps

Putting It Together

Baseline: 10-year Treasury + CRE equity risk premium = ~6.5-8.5%

Plus/minus property-specific adjustments

Typical result for a stabilized investment-grade corporate-guaranteed net lease deal on a quality location: 7.5-9% discount rate.

Typical result for a franchisee-operated deal in a secondary market with 8 years remaining: 9.5-12% discount rate.

Typical result for a value-add deal with tenant credit issues: 12-15%+.

Common Mistakes

Several errors that show up in net lease DCF analyses:

1. Confusing Discount Rate with Cap Rate

These are different. Cap rate is NOI divided by purchase price — a snapshot metric at a single point in time. Discount rate is the rate used to discount future cash flows in a DCF.

In theory, discount rate minus NOI growth rate equals cap rate (for a simple constant-growth valuation). In practice, they're different numbers reflecting different assumptions.

A common error: using the purchase cap rate as the discount rate. This implicitly assumes NOI grows at zero rate over the hold period — usually unrealistic.

2. Not Adjusting for Specific Risk

Using a "market discount rate" without adjusting for the specific deal's credit, location, lease structure, and term. This produces valuations that don't reflect the actual risk profile of the deal.

3. Dogmatic Precision

"The discount rate is 8.15%" implies false precision. Discount rates should be selected at 25 bps increments typically. If you can't defend 8.15% vs 8.00% based on specific evidence, use 8.00%.

4. Back-Solving

Selecting a discount rate to hit a desired valuation number. This defeats the purpose. The discount rate should drive valuation, not be adjusted to produce a pre-determined valuation.

5. Ignoring Sensitivity

Any serious DCF includes sensitivity analysis showing how valuation changes with different discount rate assumptions. A single-point valuation with one discount rate misses the uncertainty inherent in the approach.

A Practical Example

A hypothetical Dollar General net lease deal:

• Tenant: Dollar General (investment-grade corporate-guaranteed)
• Location: small-town Ohio, secondary market
• Initial term: 15 years; 12 years remaining
• Rent: $150,000 per year, flat for initial term (no escalations)
• Purchase price target: $2,500,000 (6% cap rate)

Discount rate build-up:

• 10-year Treasury: 4.5% (illustrative)
• CRE equity risk premium: +4.0% → 8.5% baseline
• Investment-grade tenant, NNN corporate guaranty: 0 bps
• Secondary market location: +50 bps
• Standard remaining term: 0 bps
• Flat rent structure (no escalations): +25 bps (reflects real-dollar erosion over time)
• Total discount rate: 9.25%

DCF construction:

• Year 1-12 rent: $150K (flat)
• Year 12 terminal value: $150K / 7% exit cap = ~$2.14M
• NPV at 9.25% discount rate: ~$2.3M

Implied valuation: ~$2.3M — about 8% below the $2.5M purchase price. This either:

• Argues for a lower purchase price ($2.3M = 6.5% cap)
• Or requires higher NOI growth assumptions that aren't in the lease
• Or suggests the discount rate is too aggressive and should be reconsidered

The DCF doesn't produce a "right answer" — it frames the discussion of what assumptions justify the target purchase price.

Sensitivity Analysis

Always run sensitivity on the discount rate. A reasonable format:

Each row tells a different story about the deal. The "right" valuation depends on which row best reflects the deal's actual risk profile.

Typical Ranges by Category

For net lease investments across typical market conditions:

These are ranges, not absolute rules. Specific deals land where they land based on their actual risk profile.

The Bottom Line

Discount rate selection is both art and science — the framework is systematic but the specific numbers require judgment based on deal-specific facts. The build-up method forces you to name each component, which makes the final rate defensible and replicable.

For any DCF on a significant deal, document the discount rate build-up alongside the valuation. The documentation protects you in deal discussions, appraisal reviews, and future deal comparisons. A discount rate you can defend is the starting point of a valuation you can defend.

Editorial disclaimer. This article is published by Trestle Research for informational purposes only. It is not investment, tax, or legal advice. The specific ranges and adjustments above are directional and not prescriptive; actual discount rate selection requires deal-specific analysis. Always consult qualified appraisers and financial advisors on specific valuations.

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