An appraiser is developing a discounted cash flow (DCF) model for a newly constructed office building with a 7-year holding period. The property is expected to generate net operating income (NOI) of $250,000 in Year 1, increasing at 3% annually thereafter. The reversion value at the end of Year 7 is estimated at $4,200,000 using a terminal capitalization rate of 6.5%. The investor’s required yield (discount rate) is 7.2%. Which component of the DCF model must be discounted using the 7.2% rate?
Correct Answer
C) All future cash flows — both annual NOI and the reversion — must be discounted at 7.2%
Under USPAP Standards Rule 1-4 and the Income Approach guidance in the Appraisal of Real Estate (15th ed.), all future benefits (i.e., each year’s NOI and the reversion) must be discounted to present value using the investor’s required yield (discount rate) — here, 7.2%. The 3% is the NOI growth rate, not a discount rate; it affects the magnitude of each year’s NOI but not the discount rate applied. Using different rates for different components violates the internal consistency requirement of a DCF model.
Why This Is the Correct Answer
Option C states the rule: every future cash flow, the annual NOI stream and the reversion alike, is discounted at 7.2 percent. The development standard requires the appraiser to analyze the effect on value of anticipated future benefits, and yield capitalization accomplishes that only when the rate reflecting the investor's required return is applied uniformly across the timeline. Applying it to part of the cash flows would value identical dollars from the same asset differently depending on the label attached to them.
Why the Other Options Are Wrong
Option A: Only the reversion value
Discounting only the reversion leaves seven years of income undiscounted, treating a dollar received in Year 6 as worth the same as a dollar today. The result overstates value substantially and is not a present value at all. The choice is tempting because reversion discounting is the step candidates practice most.
Option B: Only the NOI for Year 7
Year 7 NOI is one cash flow among seven; discounting it alone ignores Years 1 through 6 and the reversion. No valuation model discounts a single interior year while leaving its siblings at face value. This option also confuses the year used to derive a terminal value with the only year that matters.
Option D: The NOI stream must be discounted at 3% (the growth rate), and the reversion at 7.2%
The 3 percent figure is a growth rate that shapes the size of each year's income; it is not a time-value rate and cannot discount anything. Applying different rates to cash flows from the same investment breaks the internal consistency of the model. Growth belongs in the numerator of each year's cash flow, never in the denominator.
One Rate Rules the Timeline
In a DCF, one rate discounts everything on the timeline: the yield rate. Growth shapes the cash flows, the terminal cap rate creates the sale price, and the yield rate brings them all home. Three jobs, three rates, never swapped.
How to use: When a stem lists several percentages, label each before answering: which builds the cash flow, which converts income into a price, and which moves money through time. A discounting question always answers to the last one.
Exam Tip
If an option applies different discount rates to different cash flows of the same asset, eliminate it on sight. That is almost always the wrong answer on a DCF item.
Common Mistakes to Avoid
- -Discounting the reversion at the terminal capitalization rate
- -Treating a growth rate as a discount rate
- -Deriving a terminal value from the current year's NOI rather than the first year after the holding period
Concept Deep Dive
Analysis
A discounted cash flow model has one discount rate, the investor's required yield, and it applies to every future benefit the investment produces. Each year's net operating income and the reversion at the end of the holding period are all converted to present value at that single rate because they are all claims on the same asset carrying the same risk in the buyer's eyes. The other percentages in the stem do different jobs: the 3 percent growth rate determines how large each year's NOI becomes, and the 6.5 percent terminal capitalization rate converts income expected after the holding period into a sale price at the end of Year 7. Confusing those roles is the classic internal consistency failure in a DCF.
Background Knowledge
You need to distinguish four rates that appear in income work: the discount or yield rate, the growth rate, the going-in capitalization rate, and the terminal capitalization rate. You also need the structure of yield capitalization, in which each periodic cash flow and the reversion are discounted individually and then summed.
Real-World Application
Investors underwriting an office building hold the yield rate constant across the hold and stress-test the terminal capitalization rate separately, because lenders and equity partners want to see how much of the value depends on the assumed exit rather than on operations.
More Income Approach Questions
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NOI is $154,000 and the market overall rate is 6.8%. The indicated value is:
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In a discounted cash flow analysis for a ground lease with 40 years remaining, the appraiser projects level annual ground rent of $120,000 and estimates a reversion (fee simple value at lease expiration) of $3,000,000. The appraiser selects a 5.0% yield rate for the leasehold interest. Which statement accurately describes how the reversion is treated in this analysis?