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An appraiser develops two DCF models for the same industrial warehouse: Model A uses a 6.0% yield rate and a 5.5% terminal cap rate; Model B uses a 7.2% yield rate and a 6.8% terminal cap rate. All other assumptions (NOI projections, holding period, reversion timing) are identical. Assuming both models are properly constructed, what is the most likely effect on the indicated value?

Correct Answer

C) Model A will indicate a higher value because a lower yield rate increases the present value of all future cash flows.

Present value is inversely related to the discount (yield) rate: a lower yield rate increases the present value of all future cash flows (NOI and reversion). While terminal cap rate affects the *size* of the reversion (higher cap rate → lower reversion), the dominant influence on total present value in most DCF models is the yield rate applied to discounting. Here, Model A’s 6.0% yield rate (vs. 7.2% in Model B) will produce higher present values for every cash flow, outweighing the effect of its slightly lower terminal cap rate. USPAP and appraisal theory do not require yield rate > terminal cap rate; the relationship depends on growth expectations and risk. Option C correctly identifies the primary driver of value difference.

Answer Options

Model A will indicate a higher value because its yield rate is lower than its terminal cap rate.

Model B will indicate a higher value because its terminal cap rate is higher.

Model A will indicate a higher value because a lower yield rate increases the present value of all future cash flows.

Both models will indicate identical values since the spread between yield and terminal cap rate is the same (0.5%).

Why This Is the Correct Answer

Present value moves inversely with the discount rate, so Model A's 6.0% yield rate produces a higher present value for each year of projected NOI and for the reversion than Model B's 7.2% does. Model A also happens to use the lower terminal cap rate, which produces the larger reversion, so both of its rate choices push value in the same direction. When two inputs push the same way there is no offset to weigh and the higher-value model is determined. Choice C is the only option that identifies the discount rate as the driver and states the relationship in the right direction.

Why the Other Options Are Wrong

Option A: Model A will indicate a higher value because its yield rate is lower than its terminal cap rate.

This arrives at the right model by a comparison that carries no valuation meaning. Whether a model's yield rate sits above or below its own terminal cap rate reflects the growth and risk story built into the projection; it does not tell you how that model's value compares to another model's. Reasoning that a rate ordering inside one model determines a value ranking across two models is the trap here.

Option B: Model B will indicate a higher value because its terminal cap rate is higher.

A higher terminal cap rate divides the post-holding-period income by a larger number, so it produces a smaller reversion, not a larger one. The option inverts the direct capitalization relationship, treating the cap rate as if it multiplied income. On top of that, Model B also discounts at the higher yield rate, so both of its inputs push value down.

Option D: Both models will indicate identical values since the spread between yield and terminal cap rate is the same (0.5%).

The spread between the yield rate and the terminal cap rate is not what discounts anything; the level of the yield rate is. Two models can share an identical 0.5 point spread and still be a full percentage point apart on the discount rate, which changes the present value of every cash flow and of the reversion. Equal spreads describe similar growth expectations, not equal value.

Level Discounts, Spread Explains

The level of the yield rate decides how hard every future dollar is squeezed. The spread between the yield rate and the terminal rate only explains the growth and risk story behind the projection. Lower level, higher value, every time.

How to use: When a stem changes two rates at once, ask which way each one pushes value. If both push the same way, name that direction and stop; if they conflict, the yield rate usually decides because it compounds across the whole projection.

Exam Tip

Qualitative DCF questions rarely need a calculator. Check the direction of each rate change first, and be suspicious of any option whose stated reason is a comparison between two rates inside the same model.

Common Mistakes to Avoid

-Treating the terminal cap rate as the dominant input because it applies to the largest single cash flow
-Assuming appraisal theory requires the yield rate to exceed the terminal cap rate
-Believing that an equal spread between the two rates makes two models produce the same value

Concept Deep Dive

Analysis

A discounted cash flow model carries two rates that do very different jobs, and the question is whether you can keep them straight. The yield rate is the discount rate: it converts every future dollar in the model, both the annual net operating income and the reversion, into present value, and because the discounting compounds year after year, its influence reaches every line of the projection. The terminal capitalization rate has one narrow job, which is to convert the first year of income after the holding period into a single reversion figure at the end of the projection; that figure is then discounted back like any other cash flow. Model B raises both rates at once, so it squeezes every cash flow harder and also produces a smaller reversion to squeeze, which means the direction of the difference is unambiguous without any arithmetic. Nothing in appraisal theory requires a model's yield rate to sit above or below its own terminal rate, because that spread is a statement about expected income growth and risk, not a statement about value level.

Background Knowledge

You need the mechanics of a DCF model: annual cash flows and a reversion, each discounted at the yield rate over the holding period, with the reversion derived by capitalizing the first post-holding-period NOI at a terminal rate. You also need the inverse relationship between discount rate and present value, and the direct capitalization relationship in which a higher rate produces a lower capitalized figure.

Real-World Application

A reviewer receives two DCF analyses of the same distribution warehouse from a borrower and a lender. The lender's model uses higher rates on both lines and lands 12 percent below the borrower's, and the review comment focuses on supporting the yield rate from investor surveys and paired transactions rather than arguing over the half-point spread.

yield rateterminal capitalization ratediscounted cash flowpresent value

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