A ten-year DCF attributes 60% of present value to the terminal benefit. What does that warrant?
Correct Answer
B) Careful support and sensitivity testing of terminal assumptions.
A 60% reversion share means terminal assumptions materially affect total value, so examine terminal NOI, sale costs, timing and capitalization as well as the discount rate. The share alone does not prove one input dominates every sensitivity or establish that the holding period is correct.
Why This Is the Correct Answer
Option B is correct because a 60% reversion share means terminal assumptions materially affect total value. Income and value assumptions should be well supported and carefully analyzed, so the appraiser supports and stress-tests the terminal inputs.
Why the Other Options Are Wrong
Option A: Proof that the ten-year holding period chosen is correct.
Option A, proof that the ten-year holding period is correct, does not follow. A large reversion share says nothing about whether the chosen holding period is right; it only shows how much the terminal assumptions matter.
Option C: A conclusion that the discount rate has no material effect.
Option C, a conclusion that the discount rate has no material effect, is wrong because the discount rate applies to the reversion as well as the annual cash flows. A large reversion share makes value sensitive to the discount rate too.
Option D: Automatic acceptance of any terminal cap rate within a survey.
Option D, automatic acceptance of any terminal cap rate within a survey, ignores the need for support specific to the property and its expected condition at resale. A heavily weighted reversion calls for more scrutiny of the terminal rate, not less.
Heavy tail, test the tail
When the end of the forecast carries most of the value, the assumptions at the end deserve the most testing.
How to use: Use this reminder when a DCF question highlights a large reversion share.
Exam Tip
Prefer answers that call for support and testing of key assumptions over answers that treat a single figure as proof.
Common Mistakes to Avoid
- -Assuming a large reversion share validates the holding period
- -Ignoring the discount rate's effect on the reversion
- -Accepting a survey terminal cap rate without property-specific support
Concept Deep Dive
Analysis
This question tests how to respond when the reversion makes up a large share of DCF value. When 60% of present value comes from the terminal benefit, terminal assumptions strongly affect the result. That calls for careful support and sensitivity testing of terminal NOI, the terminal cap rate, sale costs, timing and the discount rate.
Background Knowledge
In a DCF, the reversion, also called the terminal value, is the property's estimated value or sale proceeds at the end of the holding period, discounted to present value. When the reversion is a large share of total value, small changes in terminal NOI or terminal cap rate can shift the conclusion significantly. Sensitivity analysis shows how much value changes as key inputs vary.
Real-World Application
An appraiser's ten-year DCF for an office building shows that the discounted sale at year ten accounts for 60% of value. The appraiser runs scenarios with different terminal cap rates and terminal NOI levels to show the reader how sensitive the conclusion is.
More Income Approach Questions
Which model describes yield capitalization of property benefits?
An appraiser is valuing a duplex. A market survey of recent duplex sales reports prices at 10.8 times potential gross income, with stabilized vacancy and credit loss of 10% of PGI and no other income. The subject's rent schedule is unavailable, but the property manager's records show collected income of $54,000 a year, in line with market rent and the 10% market loss. What value is indicated?
The subject property is a fourplex with annual EGI of $72,000 and operating expenses of $28,800. Of those expenses, $18,000 is fixed and $10,800 varies in direct proportion to EGI. The owner's annual mortgage payments are $21,000. An appraiser projects that EGI will fall 10% because of higher vacancy. What is the projected NOI?
Annual NOI available for debt service is $168,000 and total annual mortgage principal and interest debt service is $120,000. What is NOI ÷ debt service?
Annual PGI is $250,000 and combined vacancy and collection loss is explicitly 12% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $360,000 and combined vacancy and collection loss is explicitly 8% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $640,000. Combined vacancy and collection loss is 6.25% of PGI. There is no other income. What EGI remains?
An appraiser is updating a prior appraisal of a triplex with potential gross income of $60,000 and no other income. The prior appraisal used vacancy and credit loss of 5% of PGI, and a new survey of competing rentals indicates 8%. The operating expenses of $24,000 are property taxes, insurance and contract services that do not vary with occupancy, and the market overall rate remains 7.5%. By what percentages do effective gross income and indicated value decrease?
Annual potential rental income is $600,000 and vacancy loss alone is $36,000. What percentage of potential rent does that loss represent?
In the subject's market, lenders on fourplexes have lowered their typical loan-to-value ratio from 70% to 60%. The annual mortgage constant remains 5% and the equity dividend rate remains 10%. The subject's NOI has not changed. How does this affect the overall rate indicated by the band of investment and the indicated value?
People Also Study
Real Estate Market
13.6% of exam
Property Description
11.8% of exam
Land or Site Valuation
4.5% of exam
Sales Comparison Approach
16.4% of exam
Cost Approach
13.6% of exam
Previous Question
The equity interest in a property is known to be worth $300,000, and its annual equity dividend rate is 10%. Annual NOI is $72,000 and the mortgage constant is 7%. What total property value does the mortgage residual technique indicate?
Next Question
A client plans to build a 10-unit apartment building and needs a completed value of $1,800,000. The overall rate for similar properties is 7.5%. Forecast operating expenses are $81,000, laundry income net of losses is $4,500, and vacancy and collection loss is 10% of potential rental income. The client paid $350,000 for the land. What annual potential rental income is required?