Building A (new, credit tenant, 20-year lease) and Building B (older, month-to-month tenants) sell the same week. Their cap rates should differ how?
Correct Answer
C) Lower for A — safer income commands a lower rate and higher multiple
Why this is correct: The governing concept is that capitalization rates reflect the risk associated with the income stream. Lower cap rates indicate lower risk and higher value per dollar of NOI. Building A, with a new building, credit tenant, and long-term lease, represents safer, more durable income, so it should command a lower cap rate (higher value) compared to Building B with older physical condition and month-to-month tenants, which carries higher rollover risk. Why the other choices are wrong: "A lower for B, rewarding its flexibility" is incorrect because month-to-month tenancy increases risk, typically requiring a higher cap rate, not lower. "Identical rates, since both buildings are the same property type" is incorrect because cap rates vary within a property type based on specific risk factors. "Higher for A, since new buildings cost more" is incorrect because higher construction cost does not directly dictate a higher cap rate; risk drives the rate. Exam tip: Cap rates are risk premiums; safer income streams are capitalized at lower rates.
Why This Is the Correct Answer
Option C states the relationship correctly: the safer income stream of Building A is capitalized at a lower rate, which is the same thing as a higher multiple of income. Buyers pay more for each dollar of predictable, contractually secured income than for each dollar of income that must be re-leased repeatedly at unknown rents. The appraiser should still confirm the relationship with extracted rates from local sales, since lease duration cuts both ways in a rising rent market where short tenancies allow faster repricing.
Why the Other Options Are Wrong
Option A: A lower for B, rewarding its flexibility
Month-to-month tenancy is flexibility for the tenant and exposure for the owner, since income can end on short notice and re-leasing costs money and time. Flexibility can be worth something when rents are climbing fast, but as a general rule it raises risk rather than lowering it. The option inverts the risk relationship.
Option B: Identical rates, since both buildings are the same property type
Property type is only one of the factors priced into a rate; tenancy quality, lease term, location, age, condition, and market conditions all move it. Identical rates would imply investors are indifferent between contractual and at-will income, which no market shows. Treating a property type as a single rate is the error behind many unsupported capitalization conclusions.
Option D: Higher for A, since new buildings cost more
Construction cost does not set the capitalization rate; the risk and durability of the income stream do. A newer building generally supports a lower rate because it needs less capital and attracts stronger tenants, so this option gets the direction backward as well as the reasoning. Cost and rate are answers to different questions.
Safe Income, Small Rate
Safer income earns a smaller rate and a bigger price. Say it as a seesaw: risk up, rate up, value down; risk down, rate down, value up.
How to use: When two properties are compared, list which income stream a buyer would trust more, then assign the lower rate to that one before reading the options.
Exam Tip
Whenever a stem contrasts a credit tenant with short-term tenancies, the answer almost always involves the lower rate attaching to the credit tenant. Check the direction of the option carefully, since distractors often reverse it.
Common Mistakes to Avoid
- -Applying one capitalization rate to an entire property type
- -Confusing the direction of the rate and value relationship
- -Ignoring rollover and capital expenditure risk when comparing rates
Concept Deep Dive
Analysis
A capitalization rate is the market's price for risk expressed as a ratio of net operating income to value, so anything that makes an income stream more certain pushes the rate down and the value per dollar of income up. Building A offers a new structure with low near-term capital needs, a credit tenant whose payment ability is documented, and twenty years of contractual income, which together minimize vacancy, collection, and rollover risk. Building B offers month-to-month tenancies that can vanish with thirty days notice, plus an older structure with shorter remaining component lives and higher expected capital spending. Investors price that difference by demanding a higher return per dollar invested, which is exactly what a higher capitalization rate expresses.
Background Knowledge
You need the relationship among net operating income, capitalization rate, and value, and the fact that rate and value move inversely. You also need to know the risk factors investors price, including tenant credit, lease term, rollover exposure, building age and condition, and market conditions, and how rates are extracted from comparable sales.
Real-World Application
An investor comparing a net-leased pharmacy with fifteen years remaining against a multi-tenant strip center with rolling short leases accepts a materially lower rate on the pharmacy, and the appraiser extracts both rates from local sales to support the difference.
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Previous Question
A small commercial building has potential gross income of $120,000 annually. The appraiser analyzes three comparable properties, which have stabilized vacancy and collection losses of 8%, 9%, and 7.5%. The subject property's owner provides records showing a 5% vacancy rate over the past three years due to long-term tenants. What is the appropriate stabilized vacancy and collection loss rate to use in estimating effective gross income?
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The discount rate in a DCF differs from a capitalization rate in that it: