A DCF projection assumes rents grow 3% annually for ten years in a market where rents have been flat for five. The appraiser must:
Correct Answer
A) Support the growth assumption or revise it
Support the projected growth with relevant forward-looking market evidence or revise it. Historical flat rents warrant scrutiny but do not prove future growth is impossible. Client expectations alone are insufficient, expense growth requires its own analysis, and extending the horizon does not cure an unsupported assumption.
Why This Is the Correct Answer
Option A is correct because projected rent growth is an assumption that needs support from relevant market evidence. Five years of flat rents does not prove growth is impossible, but it does mean a 3% annual growth rate cannot simply be accepted. The appraiser either supports it or changes it.
Why the Other Options Are Wrong
Option B: Adopt the assumption because clients expect growth
Option B, adopting the assumption because clients expect growth, lets client expectations replace market evidence. Credible results need support by relevant evidence and logic, not by what a client wants.
Option C: Apply the same growth rate to the expenses
Option C, applying the same growth rate to expenses, does not test whether the rent growth is supported. Expense growth needs its own analysis and does not cure an unsupported rent projection.
Option D: Extend the projection period to twenty years
Option D, extending the projection to twenty years, lengthens the period over which an unsupported assumption compounds. A longer horizon does not supply evidence for the growth rate.
Support it or revise it
Each key DCF input needs market support; if the evidence is not there, change the input.
How to use: Use this phrase when a question asks how to handle a questionable projection.
Exam Tip
Choose the answer that ties the assumption to market evidence rather than to client wishes or model mechanics.
Common Mistakes to Avoid
- -Accepting a client's pro forma growth rate without testing it
- -Assuming flat past rents prove future growth is impossible
- -Lengthening the holding period to dilute a weak assumption
Concept Deep Dive
Analysis
This question tests whether an appraiser can accept a DCF growth assumption that conflicts with recent market history. Projections must rest on relevant market evidence. Flat historical rents call for scrutiny, so the assumption must be supported with forward-looking evidence or revised.
Background Knowledge
A discounted cash flow analysis is only as credible as its inputs, including rent growth, expense growth, vacancy and the reversion. Market analysis, such as household formation and income levels in the market area, is used to judge whether projected rents are supportable.
Real-World Application
A developer's pro forma shows 3% annual rent growth for an apartment complex in a submarket with flat rents for five years. The appraiser researches new supply, employment and household income before deciding whether that growth is supportable or a lower rate should be used.
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Previous Question
The subject property is a retail building leased to one tenant at base rent of $120,000 a year plus overage rent of 5% of annual sales above $1,000,000. Last year's sales were $1,160,000, and the appraiser projects stabilized sales of $1,240,000. Stabilized vacancy and credit loss is 5% of total rent, annual property expenses are $36,300, and the market overall rate is 8%. What is the indicated value of the leased fee interest by direct capitalization?
Next Question
The subject property is a 15-unit apartment building with potential gross income of $300,000, valued using an 8% overall rate. A competing complex has opened, and the appraiser raises stabilized vacancy and collection loss from 5% to 7% of PGI. The insurance premium rises $4,000 per year, and owner-paid utilities fall $1,500 per year at the lower occupancy. The overall rate does not change. What is the decrease in indicated value?