LOS a: Explain the relationship between a real estate capitalization rate and discount rate.

Q1. Which of the following statements most accurately describes the capitalization rate used for real estate valuation?

A)   The capitalization rate is the rate of return that equity investors require on similar-risk real estate investments.

B)   The capitalization rate is one plus the constant growth rate of net operating income.

C)   The capitalization rate is the rate of return that equity investors require on similar-risk real estate investments net of the expected constant growth rate of net operating income.

Q2. Which of the following statements is most accurate regarding real estate capitalization rates?

A)   Generally, as interest rates increase, capitalization rates increase and value estimates decline.

B)   As the difference between the required return on equity capital and the growth rate in NOI (g) increases, value estimates will also increase.

C)   If during periods of rising inflation, there is an increase in net operating income (NOI) and the growth rate of NOI, capitalization rates and value estimates will increase.

Q3. All of the following statements accurately describe the real estate capitalization rate EXCEPT:

A)   holding all else constant, market value estimates increase as the growth rate in net operating income increases.

B)   holding all else constant, the risk of a real estate investment is directly related to its estimated value.

C)   there is an inverse relationship between estimated market values and capitalization rates.

LOS a: Explain the relationship between a real estate capitalization rate and discount rate. fficeffice" />

Q1. Which of the following statements most accurately describes the capitalization rate used for real estate valuation?

A)   The capitalization rate is the rate of return that equity investors require on similar-risk real estate investments.

B)   The capitalization rate is one plus the constant growth rate of net operating income.

C)   The capitalization rate is the rate of return that equity investors require on similar-risk real estate investments net of the expected constant growth rate of net operating income.

Correct answer is C)

The capitalization rate (C) is the rate of return that equity investors require on similar-risk real estate investments (k) net of the expected constant growth rate of net operating income (g). That is, C = k -

Q2. Which of the following statements is most accurate regarding real estate capitalization rates?

A)   Generally, as interest rates increase, capitalization rates increase and value estimates decline.

B)   As the difference between the required return on equity capital and the growth rate in NOI (g) increases, value estimates will also increase.

C)   If during periods of rising inflation, there is an increase in net operating income (NOI) and the growth rate of NOI, capitalization rates and value estimates will increase.

Correct answer is A)

Where:

MV = estimated market value

NOI = the net operating income from a real estate investment.

k = the rate that equity investors require from a real estate investment.

g = the growth rate of NOI (assumed to be constant).

C = k – g = the market capitalization rate.

From this relationship, we see that: 

§   as the growth rate of NOI increases, capitalization rates decline and value estimates will rise,

§   the capitalization rate is the spread between k and g. Thus, as the spread widens, value estimates decline, and

§   holding k constant, value is directly related to g.

The effect of inflation on value estimates depends on its combined effect on the required return (k) and the growth rate (g). If the net result is to decrease (increase) the capitalization rate, value estimates will rise (fall).

Q3. All of the following statements accurately describe the real estate capitalization rate EXCEPT:

A)   holding all else constant, market value estimates increase as the growth rate in net operating income increases.

B)   holding all else constant, the risk of a real estate investment is directly related to its estimated value.

C)   there is an inverse relationship between estimated market values and capitalization rates.

Correct answer is B)

Where:

MV = estimated market value

NOI = the net operating income from a real estate investment.

k = the rate that equity investors require from a real estate investment.

g = the growth rate of NOI (assumed to be constant).

C = k – g = the market capitalization rate.

As the riskiness of a real estate investment increases, the uncertainty of its future cash flows increases. This has the effect of increasing investors’ required return (k) and increasing the capitalization rate. As cap rates rise, values decline.