Discounting a projected cash flow stream requires:
Correct Answer
C) A rate reflecting the risk of receiving those flows
Choose a supported discount rate consistent with the risk, timing, cash-flow definition and appraised interest. A loan coupon, historical return or single-period cap rate is not automatically the relevant discount yield. A simplistic risk-premium sum is not a universal rate-development formula.
Why This Is the Correct Answer
Option C is correct because projected cash flows are discounted at a supported rate that reflects the risk of receiving them. That rate should be consistent with the timing, the cash-flow definition and the property interest appraised.
Why the Other Options Are Wrong
Option A: The lender's current mortgage interest rate on the loan
Option A is wrong because the lender's current mortgage interest rate reflects the lender's position on a loan, not the risk of the property's full cash flows. A loan rate is not automatically the right discount yield.
Option B: The property's historical rate of return
Option B is wrong because the property's historical rate of return looks backward and does not necessarily reflect the risk of the future cash flows being projected.
Option D: The market's average capitalization rate
Option D is wrong because the market's average capitalization rate is a single-period income-to-value ratio, not a yield rate for discounting a multi-period cash flow stream. A cap rate is not automatically the relevant discount rate.
Risk Sets the Rate
The riskier it is to collect the cash, the higher the rate used to discount it.
How to use: Use this phrase to choose between a risk-based yield and other rates offered as answers.
Exam Tip
Pick the answer that ties the discount rate to the risk of the projected cash flows rather than to a loan rate, past returns or a cap rate.
Common Mistakes to Avoid
- -Using the mortgage interest rate as the discount rate
- -Treating a cap rate as interchangeable with a discount rate
- -Relying on historical returns instead of forward-looking risk
Concept Deep Dive
Analysis
This question tests what kind of rate is used to discount projected cash flows. The discount rate should reflect the risk of actually receiving those flows, consistent with their timing, definition and the interest being appraised. Other rates, such as a loan coupon, a historical return or a cap rate, measure different things.
Background Knowledge
In a discounted cash flow analysis, expected cash flows are discounted at a risk-adjusted rate. A yield or discount rate measures total return over the holding period, while a capitalization rate converts a single year's income to value. Higher risk calls for a higher discount rate, which lowers present value.
Real-World Application
An appraiser selecting a discount rate for a multi-tenant office DCF reviews investor surveys and comparable sales yields for similar properties. A building with weaker tenants and near-term lease expirations gets a higher rate than a fully leased building with strong credit tenants.
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A 10-unit apartment building with identical units is listed for $1,083,000. Similar buildings sell at an effective gross income multiplier of 9.5, and stabilized vacancy/credit loss is 5% of PGI. There is no other income. What monthly rent per unit is needed to justify the list price?