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Alternative Investments【Reading 45】Sample

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)
there is an inverse relationship between estimated market values and capitalization rates.
C)
holding all else constant, the risk of a real estate investment is directly related to its estimated value.




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.

Which of the following statements is most accurate regarding real estate capitalization rates?
A)
As the difference between the required return on equity capital and the growth rate in NOI (g) increases, value estimates will also increase.
B)
Generally, as interest rates increase, capitalization rates increase and value estimates decline.
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.




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).

TOP

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



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 - g.

TOP

Assume you have estimated that a shopping center investment will provide a 3.5 percent appreciation-adjusted return, a 3 percent liquidity premium, and a one percent risk premium. If the prevailing rate on government bonds, net of real estate tax savings, is 6.25 percent, the capitalization rate determined using the built-up technique is closest to:
A)
14.75%.
B)
14.00%.
C)
13.75%.



The current capitalization rate (C0) may be expressed as:
C0 = pure rate + liquidity premium + recapture premium + risk premium.
= 6.25 + 3.00 + 3.50 + 1.00 = 13.75%.

TOP

Which of the following methods calculates the market capitalization rate by including a sinking fund factor?
A)
Band-of-investment method (BOI).
B)
Market extraction method.
C)
Built-up method.



The BOI utilizes a weighted average cost of capital as an estimate of the market capitalization rate. It is appropriate for properties that utilize both debt and equity financing. In the BOI method, we adjust the capitalization rate by adding a sinking fund factor.

TOP

When estimating a capitalization rate, which of the following methods is most appropriate for a real estate investment that is financed with both debt and equity?
A)
Built-up method.
B)
Band-of-investments method.
C)
Comparable-sales method.


The band-of-investments method recognizes the relative costs of debt and equity. Under this method, the capitalization rate, C0, is represented as:
C0 = (mortgage weight × mortgage cost) + (equity weight × equity cost).

TOP

Consider a real estate investment that is 35% debt financed and 65% equity financed. The total mortgage cost for this property is 10% and the cost of equity financing is at a recent high of 13%. The capitalization rate for this investment as determined using the band-of-investments method is closest to:
A)
11.80%.
B)
11.95%.
C)
12.85%.


The band-of-investments method recognizes the relative costs of debt and equity. Under this method, the capitalization rate, C0, is represented as:
C0 = (mortgage weight × mortgage cost) + (equity weight × equity cost).
In this case, the capitalization rate is: (0.35)(10) + (0.65)(13) = 11.95%.

TOP

Assume that a property that you are evaluating has a gross annual income equal to $230,000, and that comparable properties are selling for 10.5 times gross income. The gross income multiplier approach provides a market value for this property that is closest to:
A)
$2,415,000.
B)
$2,587,500.
C)
$2,190,476.



Gross income multiplier technique: MV = gross income × income multiplier.
MV = $230,000 × 10.5 = $2,415,000

TOP

Assume that a property has an estimated net operating income (NOI) equal to $150,000. Further assume that comparable properties have a capitalization rate of 11%. The direct income capitalization approach provides a market value for this property that is closest to:
A)
$1,363,636.
B)
$13,636,363.
C)
$1,500,000.



TOP

Assume that a property has a gross annual income equal to $150,000, and that comparable properties have a gross income multiplier equal to 11.25. The gross income multiplier approach provides a market value for this property that is closest to:
A)
$1,625,000.
B)
$1,687,500.
C)
$1,333,333.



Gross income multiplier technique: MV = gross income × income multiplier.
MV = $150,000 × 11.25 = $1,687,500

TOP

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