Market evidence shows property A has lower income risk than B, with identical growth expectations and other relevant cash-flow conditions. What cap-rate direction is consistent with that evidence?
Correct Answer
C) A lower cap rate for A, reflecting its supported lower required return.
Under explicitly equal growth and other cash-flow conditions, stronger supported tenant credit and durable lease income can lower required return and cap rate. Building age and lease length alone do not establish a unique rate comparison if rent terms, market growth and other risks differ.
Why This Is the Correct Answer
Option C is correct because cap rates reflect the risk and return expectations of market participants. When property A carries lower income risk and other relevant conditions are equal, investors accept a lower return, which supports a lower cap rate for A.
Why the Other Options Are Wrong
Option A: A lower rate for B, because shorter leases offer flexibility to reset rents.
Option A, a lower rate for B because shorter leases offer flexibility to reset rents, introduces lease-length reasoning that the stem does not support and contradicts the stated evidence that B has higher income risk. Higher risk points to a higher, not lower, rate for B.
Option B: Identical rates, because the property type and market match.
Option B, identical rates because the property type and market match, ignores the stated difference in income risk. Matching type and market does not erase a supported risk difference.
Option D: A higher rate for A, since its building cost was higher.
Option D, a higher rate for A because its building cost was higher, relies on construction cost, which does not determine the investor's required return. Lower income risk supports a lower rate for A, not a higher one.
Less risk, lower rate
Risk and cap rate move together: safer income earns a lower cap rate and therefore a higher value per dollar of income.
How to use: Use this whenever a question compares properties that differ only in risk.
Exam Tip
Look for the phrase holding other factors equal; it means you should isolate the one stated difference and apply the risk-return relationship.
Common Mistakes to Avoid
- -Assuming higher construction cost means a higher cap rate
- -Treating properties of the same type and market as having identical rates despite different risk
- -Reversing the risk and cap rate relationship
Concept Deep Dive
Analysis
This question tests the link between risk and capitalization rates. With growth expectations and other cash-flow conditions held equal, the only difference is income risk, and investors require a lower return for lower risk. A lower required return translates into a lower cap rate for property A.
Background Knowledge
An overall capitalization rate reflects the return investors require given the risk of the income stream and its expected growth. Holding growth constant, lower risk means a lower required return and therefore a lower cap rate. Cost to build is not a driver of the cap rate.
Real-World Application
Two similar warehouses trade in the same market, but one is leased to a tenant with strong credit and the other to a weaker tenant. With similar growth prospects, the appraiser finds buyers paying a lower cap rate for the stronger-credit property.
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