Two otherwise comparable properties have the same expected income growth and measure cash flow in the same way. Market data show that investors require a higher return for one of them because of its greater risk of tenant default and turnover. How should the capitalization rates of the two properties compare?
Correct Answer
D) A higher overall capitalization rate for the higher-risk property.
With expected growth and other factors held constant, the stated market-required return difference supports a higher capitalization rate for the riskier cash flow. Tenant count alone would not prove relative risk; tenant credit, lease terms and growth also matter. No exact adjustment is quantified.
Why This Is the Correct Answer
Option D is correct because the greater the uncertainty of the income, the higher the capitalization rate at which it should be capitalized. Investors require more return for the property with greater tenant default and turnover risk, and with growth equal, that means a higher overall rate. A higher rate produces a lower value for the same income.
Why the Other Options Are Wrong
Option A: A lower overall capitalization rate for the higher-risk property.
Option A proposes a lower overall capitalization rate for the higher-risk property. That reverses the relationship; more risk with equal growth supports a higher rate, not a lower one.
Option B: The same overall rate, since the buildings are physically alike.
Option B says the same overall rate applies because the buildings are physically alike. Physical similarity does not offset a market-recognized difference in income risk, which supports different rates.
Option C: A rate set by the amount of current income from each property.
Option C says the rate is set by the amount of current income from each property. The rate reflects risk, growth and market return requirements, not the size of the income stream.
More risk, higher rate
Riskier income needs a higher cap rate, which makes the same income worth less.
How to use: Use this to decide the direction of a cap rate adjustment for risk.
Exam Tip
Check that growth and other factors are held constant before applying the risk rule. Then pick the higher rate for the riskier income.
Common Mistakes to Avoid
- -Assigning a lower rate to riskier income
- -Using the same rate for physically similar properties with different income risk
- -Assuming the rate depends on the amount of income rather than its risk
Concept Deep Dive
Analysis
This question tests the relationship between risk and capitalization rates. With growth and other factors held equal, a property whose income is less certain requires a higher return. That higher required return translates into a higher capitalization rate.
Background Knowledge
A capitalization rate reflects the market's required return and expectations about income change. When income is less certain, investors demand a higher return, which, all else equal, raises the capitalization rate and lowers value.
Real-World Application
An appraiser compares two similar strip centers, one leased to stable national tenants and one with frequent turnover among local tenants. Market evidence shows buyers pay less per dollar of income for the second center, supporting a higher capitalization rate.
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Previous Question
A property produces annual NOI of $120,000, and the land is known to be worth $400,000. Market data indicate a 6% land capitalization rate and a 10% building capitalization rate. What building value does the building residual technique indicate?
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The subject property has annual NOI of $105,000, and its building value is known to be $900,000. The land capitalization rate is 6% and the building capitalization rate is 8%. Using the land residual technique, what is the total property value?