In a discounted cash flow analysis for a commercial property, the appraiser uses a discount rate of 7.8% and a terminal capitalization rate of 6.2%. Which conclusion is supported by these rates under standard investment theory?
Correct Answer
C) The terminal cap rate being lower than the discount rate implies built-in appreciation and/or favorable market expectations.
When the terminal (or exit) capitalization rate is lower than the discount rate, it implies that the reversion value is relatively large — consistent with expectations of price appreciation or declining risk over time. This is a standard implication in investment analysis (e.g., Appraisal Institute, *The Appraisal of Real Estate*, 15th ed., p. 472). Option A is possible but not necessarily implied (appreciation isn’t guaranteed). Option B misstates the relationship: the terminal cap rate is not a required return on the reversion — it’s a market-based rate used to estimate resale value. Option D is false: USPAP and standard appraisal theory permit and often require different rates (discount rate reflects risk-adjusted return on equity; terminal cap rate reflects market pricing of similar properties at sale).
Why This Is the Correct Answer
When the terminal (or exit) capitalization rate is lower than the discount rate, it implies that the reversion value is relatively large — consistent with expectations of price appreciation or declining risk over time. This is a standard implication in investment analysis (e.g., Appraisal Institute, *The Appraisal of Real Estate*, 15th ed., p. 472). Option A is possible but not necessarily implied (appreciation isn’t guaranteed). Option B misstates the relationship: the terminal cap rate is not a required return on the reversion — it’s a market-based rate used to estimate resale value. Option D is false: USPAP and standard appraisal theory permit and often require different rates (discount rate reflects risk-adjusted return on equity; terminal cap rate reflects market pricing of similar properties at sale).
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