The capitalization rate using the built~up technique

CFA Level II
#1

Explain.

Assume you have determined that a real estate investment will provide a 2.5%

appreciation adjusted return of investment, has a 2% liquidity premium, and

has a 1% risk premium. Further, assume that the prevailing rate on government

bonds, net of real estate tax savings, is 5.25%. The capitalization rate using the

built~up technique is closest to:

A. 5.75%.

B. 10.00%.

c. 10.75%.

#2

Just add them all. what is there to explain?

#3

Everyone agrees that you just add them up?

#4

I guess so. My only question is, can we regard, the prevailing rate on government

bonds, net of real estate tax savings, is 5.25% as risk free rate here?

#5

Surely that shows it to be a “clean” rate ?..Not everyone neccesarily has the same tax position.

#6

Yes 5.25% is the relevant rate. Hint: what about “… appreciation adjusted return of investment”? What’s that?

#7

I assume that allows for the recapture premium?

#8

True, so what is the answer?

#9

The answer is A.

R = Rf + Liquidity premium + risk premium

Cap rate = r - 2.5% appreciation which is (8.25% minus 2.5%) = 5.75%

#10

annoying

#11

This came from Schweser and they selected C!

#12

C makes sense to me…

#13

C is wrong that’s why I’m posting. A is correct.

#14

So you mean schweser is not doing it right?

#15

Why do you think it’s’ A Dreary and straightjacket?

Schwesher is pretty clear (page 30 of book 4)

R = govt bond rate + liquidity premium + recapture rate + risk premium

#16

You add them up. 5.75% is a decoy for people trying to do too much. You are told to use build up method, not direct cap.

Pages 36 and 37 state this very clearly. Recapture premium = appreciation adjusted return of investment

#17

Cap rate is r-g. build up method is for calculating r. r= 2+1+5.25=8.25 8.25-2.5= 5.75

#18

Zanalyst, the appreciation-adjusted return has been adjusted for appreciation (ie. growth), so you don’t need to subtract it from r.

#19

That’s the only change I made to the question! I changed option A to 5.75%. Hang on we will get to the bottom of this later today.

#20

I don’t have the book with me here, but I don’t recall such a term as " appreciation adjusted return of investment" in CFAI. The idea they talk about is that if the real estate property is expected to appreciate/depreciate in value, or in some other execrises I think I saw that if NOI is expected to appreciate/depreciate by some percentage then you adjust the cap rate based on that. If there is appreciation of 2.5%, you DEDUCT that from the required rate/the cap rate. If it is going to depreciate then you ADD to cap rate. That makes sense.