What distinguishes a DCF discount rate from an overall capitalization rate?
Correct Answer
D) It discounts dated forecast benefits as a yield, rather than directly relating one-period NOI to value.
A DCF discount rate converts dated forecast benefits to present value; an overall cap rate relates a compatible single-period income to value. They perform different functions and need not be equal or ordered by a universal rule. Growth belongs in the explicit forecast and compatible rate selection.
Why This Is the Correct Answer
Option D is correct because a DCF discount rate is a yield rate applied to each forecast benefit according to its timing, whereas an overall cap rate relates one period's NOI directly to value. The two rates perform different functions and need not be equal or ordered by a universal rule.
Why the Other Options Are Wrong
Option A: It must be lower than the overall cap rate for the same property.
Option A claims the discount rate must be lower than the overall cap rate for the same property. No universal rule orders the two; their relationship depends on expected income and value change.
Option B: It applies only to terminal proceeds and never interim cash flow.
Option B says the discount rate applies only to terminal proceeds and not to interim cash flow. In a DCF, the discount rate is applied to both the periodic cash flows and the reversion.
Option C: It is set by the lender’s prime rate for the loan term rather than by market evidence of required returns.
Option C says the discount rate is set by the lender's prime rate for the loan term rather than by market evidence. Discount rates should reflect the returns that market participants require, not a lender's loan pricing.
Discount many, capitalize one
A discount rate works on many dated cash flows; a cap rate works on one period's income.
How to use: Use this to separate yield-capitalization questions from direct-capitalization questions.
Exam Tip
Be cautious with choices that state a fixed ordering between discount and cap rates; their relationship depends on the expected income pattern and value change.
Common Mistakes to Avoid
- -Assuming the discount rate must be below the cap rate
- -Applying the discount rate only to the reversion
- -Using a lender's loan rate as the discount rate
Concept Deep Dive
Analysis
This question tests the conceptual difference between yield capitalization and direct capitalization. A discount rate converts each dated future benefit to present value, while an overall cap rate converts a single period's income into value. Recognizing these distinct functions eliminates choices that impose fixed orderings or non-market sources.
Background Knowledge
Yield capitalization converts future benefits to present value by discounting each at an appropriate yield rate. Direct capitalization converts a single year's income expectancy into value by dividing by a rate or multiplying by a factor. Growth expectations are handled in the DCF forecast itself and in selecting compatible rates.
Real-World Application
An appraiser valuing an office building builds a 10-year DCF using a market-derived discount rate for the annual cash flows and reversion. As a cross-check, the appraiser also capitalizes first-year NOI at a market-derived overall rate.
More Income Approach Questions
Which model describes yield capitalization of property benefits?
An appraiser is valuing a duplex. A market survey of recent duplex sales reports prices at 10.8 times potential gross income, with stabilized vacancy and credit loss of 10% of PGI and no other income. The subject's rent schedule is unavailable, but the property manager's records show collected income of $54,000 a year, in line with market rent and the 10% market loss. What value is indicated?
The subject property is a fourplex with annual EGI of $72,000 and operating expenses of $28,800. Of those expenses, $18,000 is fixed and $10,800 varies in direct proportion to EGI. The owner's annual mortgage payments are $21,000. An appraiser projects that EGI will fall 10% because of higher vacancy. What is the projected NOI?
Annual NOI available for debt service is $168,000 and total annual mortgage principal and interest debt service is $120,000. What is NOI ÷ debt service?
Annual PGI is $250,000 and combined vacancy and collection loss is explicitly 12% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $360,000 and combined vacancy and collection loss is explicitly 8% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $640,000. Combined vacancy and collection loss is 6.25% of PGI. There is no other income. What EGI remains?
An appraiser is updating a prior appraisal of a triplex with potential gross income of $60,000 and no other income. The prior appraisal used vacancy and credit loss of 5% of PGI, and a new survey of competing rentals indicates 8%. The operating expenses of $24,000 are property taxes, insurance and contract services that do not vary with occupancy, and the market overall rate remains 7.5%. By what percentages do effective gross income and indicated value decrease?
Annual potential rental income is $600,000 and vacancy loss alone is $36,000. What percentage of potential rent does that loss represent?
In the subject's market, lenders on fourplexes have lowered their typical loan-to-value ratio from 70% to 60%. The annual mortgage constant remains 5% and the equity dividend rate remains 10%. The subject's NOI has not changed. How does this affect the overall rate indicated by the band of investment and the indicated value?
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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?
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Annual potential base rent for a property is $85,000, and tenants also pay the landlord potential reimbursements of $15,000. A combined loss of 8% applies to both, and the reimbursements have not already been adjusted for loss. What is the annual EGI?