An appraiser reviewing a trainee's work finds that the trainee extracted an 8% overall rate from sales of older fourplexes similar to the subject. The trainee then added 2.5 percentage points as a recapture allowance for the building's remaining economic life before capitalizing NOI. What is the main problem with this step?
Correct Answer
D) Recapture is implicit in a rate extracted from sales, so the added allowance counts capital recovery twice.
An overall rate extracted from sales implicitly provides for both the return on and the return of capital, because both are reflected in the prices buyers paid. Adding a recapture allowance therefore counts capital recovery twice and understates value. Treating recapture as an operating cost simply moves the same double count into NOI. Land is generally not a wasting asset, and recapture does not follow the term of the buyer's loan.
Why This Is the Correct Answer
Option D is correct because direct capitalization makes no separate allocation between return on and return of the investment. Those assumptions are implicit in a rate derived from comparable sales. Adding 2.5 percentage points to the extracted 8% counts capital recovery a second time, which raises the rate and understates value.
Why the Other Options Are Wrong
Option A: Recapture is an operating cost, so the allowance should be deducted from NOI and not added to the rate.
Option A treats recapture as an operating cost to deduct from NOI. Recapture is a recovery of capital rather than an expense of operating the property, and deducting it from NOI would still duplicate what the extracted rate already reflects.
Option B: Recapture relates to the land as well, so the allowance should be based on the total property value.
Option B says the allowance should relate to the land as well and be based on total property value. Land is generally treated as a non-wasting asset that needs no capital recovery, and the real problem is that the extracted rate already reflects recovery.
Option C: Recapture follows the buyer's loan payoff, so the allowance should be based on the loan's amortization term.
Option C ties recapture to the buyer's loan payoff and amortization term. Loan amortization describes how the debt is repaid, which differs from recovery of the investment in the property, and the extracted rate already reflects that recovery.
The price already priced it
Buyers considered the building's age when they set the price. A rate taken from that price has the age effect built in.
How to use: Use this reminder when a problem suggests adding anything to a rate that was extracted from sales.
Exam Tip
Check where a rate came from before adjusting it. A market-extracted overall rate differs from a rate built up from components, which may need a separate recapture element.
Common Mistakes to Avoid
- -Adding recapture to a market-extracted overall rate
- -Treating recapture as an operating expense
- -Confusing recovery of the investment with amortization of the loan
Concept Deep Dive
Analysis
The skill tested is what an overall rate contains, not how to divide by it. Buyers' prices already reflect their expectations about the recovery of the investment and the return on it, so a rate extracted from those prices carries both. The reasoning step is to see that adding recapture to such a rate duplicates something already there.
Background Knowledge
Investors expect both a return of their capital and a return on it. In yield capitalization these can be handled explicitly through compound interest and annuity factors, but direct capitalization relates one year's income to value in one step. The overall rate from comparable sales therefore carries the recovery assumption implicitly.
Real-World Application
A junior analyst worries that an 8% rate from sales of older buildings ignores their limited remaining life and adds a recapture allowance. The reviewing appraiser points out that buyers of those older buildings had already factored age into their prices. The addition is removed before the value conclusion is reported.
More Income Approach Questions
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Previous Question
Annual NOI is $96,000 and annual debt service is $48,000. The mortgage interest is valued at $400,000, and the equity dividend rate is 12%. What total property value does the equity residual technique indicate?
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A property's annual NOI is $120,000 and does not change. If the capitalization rate used in direct capitalization decreases from 8.0% to 7.5%, how does the indicated value change?