Market evidence supports higher risk and weaker income-growth prospects at a future sale than at acquisition, all else equal. What can justify a higher terminal cap rate?
Correct Answer
C) Those supported terminal risk and growth expectations.
If supported evidence anticipates greater terminal risk or reduced remaining income prospects, it can justify a higher terminal rate. Aging alone does not mandate a spread; renovations, rents and market expectations also matter. Sale costs should be modeled consistently and not silently substituted for rate support.
Why This Is the Correct Answer
Option C is correct because a cap rate should reflect the risk and return expectations of market participants. When supported evidence anticipates greater risk and weaker income growth at the future sale, a higher terminal cap rate is justified.
Why the Other Options Are Wrong
Option A: Discounting mathematics requires a positive spread in a DCF.
Option A says discounting mathematics requires a positive spread in a DCF. Nothing in the math forces a spread; any difference between terminal and going-in rates must be supported by market expectations.
Option B: Terminal cap rates must contain selling costs.
Option B says terminal cap rates must contain selling costs. Selling costs are typically modeled as a separate deduction from the sale price and should not be silently built into the rate as a substitute for rate support.
Option D: All lenders mandate the same higher exit rate.
Option D claims all lenders mandate the same higher exit rate. Terminal rates are supported by market evidence of investor expectations, not by a uniform lender requirement.
Exit rate follows exit risk
The terminal rate tracks the risk and growth expected at the time of sale, not a fixed rule.
How to use: Use this when choosing the support for a terminal cap rate.
Exam Tip
Choose answers that tie rate selection to supported market expectations over answers citing mathematical requirements or uniform mandates.
Common Mistakes to Avoid
- -Adding a fixed spread without market support
- -Embedding selling costs in the terminal rate
- -Treating lender requirements as the source of the terminal rate
Concept Deep Dive
Analysis
This question tests what supports choosing a terminal cap rate higher than the going-in rate. Cap rates reflect market participants' risk and return expectations, so evidence of higher risk and weaker growth at the future sale supports a higher terminal rate. Mechanical rules or lender mandates are not valid support.
Background Knowledge
A terminal capitalization rate converts forecast income after the holding period into a reversion value. It is often higher than the going-in rate when the property will be older or riskier at sale, but any spread must be market supported. Selling costs are handled consistently, usually as a deduction from the gross sale price.
Real-World Application
An appraiser preparing a DCF for an aging suburban office building finds that buyers of older buildings demand higher returns because of rising capital needs. Based on that evidence, the appraiser selects a terminal cap rate above the going-in rate and deducts selling costs separately.
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Next Question
An appraiser finds a comparable that sold for a cash-equivalent price of $1,350,000 with annual PGI of $150,000. The subject has annual PGI of $128,000. Sales in the market area indicate the subject would sell at the same price-to-income ratio, and no other adjustments are needed. What is the indicated value of the subject, to the nearest dollar?