In a discounted cash flow analysis, an appraiser uses a yield rate of 10% to discount projected cash flows but applies a terminal capitalization rate of 8% to estimate the reversion. Which statement best explains why these two rates differ?
Correct Answer
A) The terminal cap rate reflects long-term market expectations for risk and growth, while the yield rate reflects the investor’s required return on the entire investment over the holding period.
The yield rate (discount rate) represents the investor’s required total return on the entire investment, incorporating risk, opportunity cost, and holding period. The terminal capitalization rate reflects market-based expectations for the property’s long-term risk, growth, and stability at the end of the holding period — it is derived from comparable sales of similar properties held in perpetuity. These rates serve distinct purposes and are not required to be equal. USPAP Advisory Opinion 21 clarifies that the discount rate and terminal cap rate may differ, as they reflect different time horizons and assumptions. Option B is false (no such requirement); C is false (they serve different functions); D misstates USPAP (no such mandate exists).
Why This Is the Correct Answer
The yield rate (discount rate) represents the investor’s required total return on the entire investment, incorporating risk, opportunity cost, and holding period. The terminal capitalization rate reflects market-based expectations for the property’s long-term risk, growth, and stability at the end of the holding period — it is derived from comparable sales of similar properties held in perpetuity. These rates serve distinct purposes and are not required to be equal. USPAP Advisory Opinion 21 clarifies that the discount rate and terminal cap rate may differ, as they reflect different time horizons and assumptions. Option B is false (no such requirement); C is false (they serve different functions); D misstates USPAP (no such mandate exists).
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