California Real Estate Practice Exam

Why is selecting an accurate capitalization rate crucial in the income approach to appraisal?

1. a property with a reliable tenant would justify a higher cap rate

2. appraised property value increases if the cap rate is decreased

3. provision for return on investment limits the cap rate calculation

4. appraised property value increases if the cap rate is increased

The correct answer is: a property with a reliable tenant would justify a higher cap rate

Selecting an accurate capitalization rate is essential in the income approach to appraisal because it directly influences the valuation of income-producing properties. The capitalization rate reflects the relationship between the property’s income and its value; thus, when a property has a reliable and stable tenant, it contributes to a consistent income stream. This reliable income justifies a lower capitalization rate, as lower rates indicate a higher value due to reduced perceived risk. When investors expect stability and reliability, they are willing to pay more, resulting in a valuation that correctly reflects the investment’s potential. Therefore, the importance of accurately determining the capitalization rate lies in its ability to provide a realistic appraisal that captures the property's income potential and risk profile. This ensures that investors make informed decisions based on the anticipated returns of the property.