Real Estate Investing Real Estate Valuation Methods 5 — Questions and Answers
Question 1: A property's NOI is $90,000 and a buyer requires a 9% return on equity with a 70% LTV mortgage at a 7% mortgage constant. What overall cap rate does the band-of-investment method produce?
- 7.6%
- 7.8% (Correct answer)
- 8.0%
- 8.2%
Correct answer: 7.8%
Cap Rate = (0.70 × 7%) + (0.30 × 9%) = 4.9% + 2.7% = 7.6%; the closest answer using standard band-of-investment is 7.6% — option A is correct (select A).
Question 2: Which approach to value is MOST relied upon when appraising a special-purpose property like a church or school?
- Sales comparison approach
- Income approach
- Cost approach (Correct answer)
- Gross rent multiplier method
Correct answer: Cost approach
Special-purpose properties rarely sell, making comparables and income data scarce; the cost approach is typically primary.
Question 3: An investor calculates an internal rate of return (IRR) of 12% on a potential acquisition but requires a minimum 15% IRR. What should the investor do?
- Proceed — IRR above 10% is always acceptable
- Negotiate a lower purchase price to increase the IRR (Correct answer)
- Switch to the cost approach for a different value
- Accept the deal because IRR and cap rate are the same metric
Correct answer: Negotiate a lower purchase price to increase the IRR
If the IRR falls below the required hurdle rate, the investor should seek a lower purchase price to improve returns or pass on the deal.
Question 4: Under USPAP (Uniform Standards of Professional Appraisal Practice), what is an 'extraordinary assumption'?
- An assumption that is always false but legally required
- An assumption about an uncertain fact accepted as true for appraisal purposes (Correct answer)
- A cap rate derived from market extraction
- A physical inspection waiver granted by the lender
Correct answer: An assumption about an uncertain fact accepted as true for appraisal purposes
An extraordinary assumption is a specific assumption about an uncertain fact that, if found to be false, could alter the appraiser's opinions or conclusions.
Question 5: A property sells for $800,000 with seller financing at below-market rates. For comparable sales analysis, how should this sale be treated?
- Used as-is since the price was agreed upon by buyer and seller
- Adjusted for the financing concession before use as a comparable (Correct answer)
- Excluded from analysis since it is not an arm's-length transaction
- Used only in the cost approach reconciliation
Correct answer: Adjusted for the financing concession before use as a comparable
Favorable seller financing inflates the sale price; an appraiser must adjust or verify the cash-equivalent price before using the sale as a comparable.
Question 6: What does the 'effective age' of a building represent in the cost approach?
- The calendar year the building was constructed
- The age indicated by the building's condition and utility relative to new construction (Correct answer)
- The remaining economic life of the building
- The number of years since the last major renovation
Correct answer: The age indicated by the building's condition and utility relative to new construction
Effective age reflects how old a building appears based on condition and maintenance, which may differ significantly from its actual chronological age.
Question 7: Which scenario best illustrates the principle of substitution in real estate valuation?
- A buyer pays $400,000 for a home when equally desirable alternatives are available for $350,000 (Correct answer)
- A seller accepts a below-market offer to close quickly
- A lender requires an appraisal before approving a mortgage
- An appraiser uses three comparable sales to bracket the subject property
Correct answer: A buyer pays $400,000 for a home when equally desirable alternatives are available for $350,000
The principle of substitution holds that a rational buyer will not pay more for a property than the cost to acquire a comparable alternative — making overpaying irrational.
Real Estate Investing Real Estate Valuation Methods 5
A property's NOI is $90,000 and a buyer requires a 9% return on equity with a 70% LTV mortgage at a 7% mortgage constant.
What overall cap rate does the band-of-investment method produce?