CFA Level II Alternative Investments Practice Questions
Question 1
An investor expects a property's net operating income next year to be USD 700,000, growing at 2% a year indefinitely. The investor's required return is 9%. What is the property value using the implied cap rate?
- A. USD 7.78 million
- B. USD 10.20 million
- C. USD 10.00 million
- D. USD 6.36 million
Show answer and explanation
Correct answer: C. USD 10.00 million
Cap rate = r - g = 9% - 2% = 7%. Value = NOI1/cap rate = 700,000/0.07 = USD 10.00 million. The implied cap rate is the discount rate less the perpetual growth rate, applied to next year's NOI. Growing the NOI again would double-count a year of growth.
- A. Capitalises at the full discount rate of 9%, ignoring income growth.
- B. Grows next year's NOI again (714,000/0.07), double-counting a year of growth.
- C. Correct: 700,000/(0.09 - 0.02) = 10.00 million.
- D. Adds growth to the discount rate (11%), the wrong sign.
Question 2
A property has potential gross income of USD 2.0 million, a vacancy and collection loss of 10% and operating expenses of USD 0.6 million. The market capitalization rate is 6%. What is the value under the direct capitalization approach?
- A. USD 23.33 million
- B. USD 20.00 million
- C. USD 30.00 million
- D. USD 33.33 million
Show answer and explanation
Correct answer: B. USD 20.00 million
EGI = 2.0 x 0.90 = 1.8; NOI = 1.8 - 0.6 = 1.2. Value = NOI/cap rate = 1.2/0.06 = USD 20.00 million. Direct capitalization divides first-year stabilized NOI by the market cap rate. NOI excludes financing costs and depreciation, and vacancy reduces potential income first.
- A. Deducts expenses from potential income but forgets the vacancy loss (1.4/0.06).
- B. Correct: 1.2/0.06 = 20.00.
- C. Capitalises effective gross income without deducting operating expenses (1.8/0.06).
- D. Capitalises potential gross income (2.0/0.06), ignoring both vacancy and expenses.
Question 3
An analyst constructs a residential real estate price index using the repeat-sales method. Which is a recognized weakness of this method relative to a hedonic index?
- A. It needs a regression on many property characteristics, which introduces specification and data-availability risk
- B. It uses appraised values rather than transaction prices, so it understates volatility and lags the market
- C. It cannot control for location, because the same property is observed in each pair of repeat sales
- D. Properties that sell more than once may not represent the whole stock, and renovations change quality between sales
Show answer and explanation
Correct answer: D. Properties that sell more than once may not represent the whole stock, and renovations change quality between sales
A repeat-sales index uses only properties that transacted at least twice, a possibly unrepresentative sample, and it assumes quality is unchanged between sales. Hedonic indexes use characteristics regressions and can use all sales, but carry specification risk.
- A. Wrong: that describes hedonic indexes, not repeat-sales indexes.
- B. Wrong: repeat-sales indexes use transaction prices, not appraisals.
- C. Wrong: observing the same property in each pair controls for location, which is a strength.
- D. Correct: sample selection and unobserved quality changes are recognized repeat-sales limitations.
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An investor builds an allocation using the return history of an appraisal-based commercial real estate index. Compared with the true underlying market returns, what bias should the investor expect in that data?
- A. Understated volatility and understated correlation with equities, which overstates diversification benefits
- B. Overstated volatility and overstated correlation with equities, which understates diversification benefits
- C. Understated volatility but overstated correlation with equities, which makes real estate look riskier
- D. Overstated volatility but understated correlation with equities, which makes real estate look safer
Show answer and explanation
Correct answer: A. Understated volatility and understated correlation with equities, which overstates diversification benefits
Appraisers rely on past values and comparable sales, which smooths and lags reported returns. This understates volatility and correlation with other asset classes, making real estate appear to offer better risk-adjusted returns and diversification than it does.
- A. Correct: smoothing damps reported swings and delays co-movement with the stock market.
- B. Wrong: smoothing reduces, not increases, measured volatility.
- C. Wrong: volatility is understated, and correlation is understated too.
- D. Wrong: smoothed data understate volatility, so real estate looks less risky, not more.