Which assignment most calls for discounted cash flow over direct capitalization?
Correct Answer
D) A half-vacant center being repositioned over three years
An explicit DCF can model the timing of repositioning costs, lease-up and changing receipts. A stabilized single income may be unrepresentative. This favors explicit forecasting here without universally banning any other supported model or declaring every flat lease automatically suitable for unadjusted direct capitalization.
Why This Is the Correct Answer
Option D is correct because a half-vacant center being repositioned over three years has irregular cash flows, with repositioning costs, lease-up and changing receipts. DCF discounts each year's cash flow separately, so it can reflect expenditures and income as they are expected to occur, while a single stabilized year may not represent this property.
Why the Other Options Are Wrong
Option A: A stabilized fourplex with long-term tenants
Option A, a stabilized fourplex with long-term tenants, has steady income that a single year's NOI can represent. Direct capitalization is well suited to that kind of stable pattern, so this assignment does not especially call for DCF.
Option B: A single-tenant building on a flat twenty-year lease
Option B, a single-tenant building on a flat twenty-year lease, produces a level and predictable income stream. That regular pattern does not create the multi-year changes that make DCF especially necessary, though the appraiser still considers the lease terms.
Option C: A leased-up office at market rents throughout
Option C, a leased-up office at market rents throughout, is already stabilized, so next year's income is a reasonable proxy for ongoing income. Direct capitalization can handle this case without an explicit multi-year forecast.
Bumpy flows need DCF
If the income line is flat, one year can stand for all; if it is bumpy, each year needs its own discounting.
How to use: Use this picture to choose between direct capitalization and DCF on method-selection questions.
Exam Tip
Look for words like lease-up, repositioning, renovation or changing occupancy as signs that a multi-year forecast is warranted.
Common Mistakes to Avoid
- -Applying a stabilized cap rate to a property that is not yet stabilized
- -Assuming a long-term lease by itself requires DCF
- -Treating the current year's depressed income as representative
Concept Deep Dive
Analysis
This question tests when discounted cash flow analysis is more suitable than direct capitalization. Direct capitalization forecasts only the next year's income, which works best when that income represents a stable pattern. When income and costs change over several years, as in a repositioning with lease-up, DCF can model each year separately.
Background Knowledge
Direct capitalization converts one year's expected income into value using a market-derived rate. DCF forecasts income and expenses for each year of a holding period plus a reversion, and discounts each to present value. DCF is especially useful for properties in lease-up, renovation or with irregular cash flows.
Real-World Application
An appraiser is engaged on a half-empty shopping center that the owner plans to renovate and re-lease over three years. Because occupancy, capital spending and rent will change each year, the appraiser builds a DCF model rather than relying on one year's income.
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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Previous Question
A client is comparing two four-unit apartment properties. Property A has PGI of $72,000, vacancy and credit loss of 8%, an operating expense ratio of 45% of EGI, and a market overall rate of 8%. Property B has PGI of $63,000, vacancy and credit loss of 4%, an operating expense ratio of 40% of EGI, and a market overall rate of 7.5%. Which property has the higher indicated value, and by how much?
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