Alternative Investments Session 13 - Reading 45

CFA Level 2 - Alternative Investments Session 13-Reading 45 (Practice Questions, Sample Questions) 1. 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. Explanation: 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. 2. 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. Explanation: 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). 3. 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. Explanation: 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. 4. 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%. Explanation: 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%. 5. 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. Explanation: 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. 6. 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. Explanation: 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). 7. 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%. Explanation: 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%. 8. 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. Explanation: Gross income multiplier technique: MV = gross income × income multiplier. MV = $230,000 × 10.5 = $2,415,000 9. 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. Explanation: Gross income multiplier technique: MV = gross income × income multiplier. MV = $150,000 × 11.25 = $1,687,500 10. All of the following are limitations to the gross income multiplier approach for real estate valuation EXCEPT: A) gross rental income may be inappropriate when building-to-land ratios are different among otherwise comparable properties. B) it may be difficult to obtain the necessary data to determine the appropriate capitalization rate. C) sales prices for comparable properties may not be current. The gross income multiplier approach does not use a capitalization rate. 11. Which of the following valuation approaches is only applicable in its application to income-generating properties? A) Both the gross income multiplier approach and the direct income capitalization approach. B) Only the direct income capitalization approach. C) Only the gross income multiplier approach. Explanation: Both valuation approaches are limited to use with income producing properties. Neither approach can provide an accurate value estimate for owner-occupied properties because the benefit derived by the owner is difficult to measure in monetary terms. 12. Discontinuous pricing, lack of rental data, and the fact that gross rents may distort appraised values are all limitations of which of the following valuation techniques? A) The gross income multiplier approach. B) The direct income capitalization approach. C) The market extraction technique. Explanation: The direct income capitalization approach does not use gross rents. The market extraction technique is not a valuation technique per se. It is a technique used to determine capitalization rates for the direct income capitalization valuation approach.