California Real Estate Broker Exam — All Questions

Which set states the four elements that must be present before a thing has value in appraisal theory?

• a.Utility, scarcity, demand and transferability✓
• b.Cost, price, income and depreciation
• c.Land, labor, capital and entrepreneurship
• d.Time, title, interest and possession

The four elements of value are utility, scarcity, demand and transferability, sometimes remembered as DUST. Remove any one and value collapses: air is useful but not scarce, and land that cannot be transferred has no market. Cost, price and income are measures used in the three approaches rather than elements of value itself. Land, labor, capital and entrepreneurship are the agents of production in economics. Time, title, interest and possession are the four unities required to create a joint tenancy, which is a co-ownership concept and not a valuation one.

A house cost $700,000 to build in 2019, recently sold for $850,000, and an appraiser's opinion places it at $830,000. Which statement correctly distinguishes the three figures?

• a.$700,000 is price, $850,000 is value, and $830,000 is the replacement cost new
• b.$700,000 is value, $850,000 is cost, and $830,000 is the price the market paid
• c.$700,000 is cost, $850,000 is price, and $830,000 is the appraiser's opinion of value✓
• d.All three figures state value, because each was produced by a market participant

Cost is what was spent to create the improvement, price is what a particular buyer actually paid in a particular transaction, and value is an opinion of worth developed under a stated definition such as market value. The three converge only by coincidence, and the exam tests that a broker keeps them apart. A single sale price can be above or below market value because of atypical motivation, unusual financing or a short marketing period, which is why an appraiser researches whether a transaction met the conditions requisite to a fair sale before using it as a comparable.

The principle of substitution holds that a prudent buyer will pay no more for a property than:

• a.The replacement cost of the improvements before any deduction for depreciation
• b.The amount the current owner originally paid, adjusted for inflation since purchase
• c.The cost of acquiring an equally desirable substitute property without undue delay✓
• d.The total of the property tax assessments levied on the parcel over the past decade

Substitution is the principle that value tends to be set by the cost of acquiring an equally desirable substitute, assuming no costly delay in making the substitution. It underlies all three approaches: comparable sales in the sales comparison approach, the cost of building an equivalent structure in the cost approach, and an alternative investment's yield in the income approach. What the current owner paid is a historical fact that the market ignores. Undepreciated replacement cost overstates value for an older building. And assessed values reflect Proposition 13 mechanics rather than current market worth.

An appraiser concludes that a corner lot improved with a small cottage would be worth more as a site for a four-unit building permitted by its zoning. This conclusion applies the principle of:

• a.Highest and best use, being the legally permissible use producing the greatest value✓
• b.Conformity, being the tendency of maximum value to arise where uses are reasonably similar
• c.Regression, being the tendency of a superior property to be pulled down by inferior neighbors
• d.Anticipation, being the present worth of the future benefits expected from the property

Highest and best use is the reasonably probable use that is legally permissible, physically possible, financially feasible and maximally productive, and it is the first analytical step in an appraisal because it determines what is being valued. Conformity concerns the similarity of surrounding uses. Regression describes the drag an inferior neighborhood exerts on a superior property, and progression the opposite. Anticipation explains why an income property is worth the present value of its expected future benefits, which matters in the income approach but is not the reasoning used here.

The most expensive house on a street of modest homes tends to sell for less than it would in a neighborhood of comparable homes. This illustrates:

• a.Contribution, in which a component adds value equal to what it adds to the whole, not its cost
• b.Progression, in which the value of a modest property is lifted by superior surrounding properties
• c.Regression, in which the value of a superior property is reduced by inferior surrounding properties✓
• d.Plottage, in which combining adjoining parcels under one owner produces added value called assemblage

Regression is the tendency of a property of higher quality to be pulled toward the level of the lesser properties around it, which is why over-improvement is a recognized valuation risk. Progression is the mirror image, lifting the modest property. Contribution measures what an individual component such as a second bathroom adds to the value of the whole, which frequently differs from what it cost to install. Plottage is the increment in value created when adjoining parcels are combined into a single larger, more useful parcel, and the process of combining them is assemblage.

In California, an opinion of value given by a real estate licensee in the ordinary course of the licensee's business, such as a competitive market analysis:

• a.Requires the licensee to hold a state-certified general appraiser credential before it is prepared
• b.Is an appraisal that must comply with the Uniform Standards of Professional Appraisal Practice
• c.May be used in place of an appraisal for any federally related mortgage loan transaction
• d.Is not an appraisal under Business and Professions Code section 11302 and may not be called one✓

Business and Professions Code section 11302(b) excludes from the definition of appraisal an opinion of value given by a real estate licensee in the ordinary course of the licensee's business in connection with a function for which a real estate license is required, and it adds that the opinion shall not be referred to as an appraisal. So a broker may prepare a competitive market analysis but must not label it an appraisal. It cannot substitute for the appraisal a federally related transaction requires, and preparing it does not require an appraiser credential.

Business and Professions Code section 10177.3 makes it a ground for discipline for a California licensee to:

• a.Knowingly or intentionally misrepresent the value of real property✓
• b.Give a client an opinion of value that later proves higher than the sale price
• c.Prepare a competitive market analysis without a written request from the seller
• d.Recommend a listing price that differs from the county assessor's assessed value

Section 10177.3 states plainly that no licensee shall knowingly or intentionally misrepresent the value of real property, and subdivision (b) adds that a licensee offering an opinion of value used as the basis for originating a mortgage loan shall not hold a prohibited interest in the property. The offense is knowing or intentional misstatement, so an honest opinion that the market later contradicts is not a violation. No statute requires a written request before a market analysis is prepared. And an assessed value under Proposition 13 often diverges sharply from market value, so a difference is expected.

Which definition matches market value as it is normally stated in an appraisal assignment?

• a.The highest price any single buyer in the market would be willing to pay under any circumstances
• b.The most probable price in a competitive and open market with both parties acting prudently✓
• c.The amount of the largest loan an institutional lender would advance against the property
• d.The sum of the land value and the undepreciated cost of constructing the improvements

Market value is the most probable price a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. The highest price any buyer would pay describes investment value to a particular purchaser, which can far exceed market value. Loan value is a lender's underwriting figure derived from value rather than a definition of it. And land plus undepreciated cost is a mechanical sum that ignores depreciation and the market.

In the sales comparison approach, when a comparable property has a feature the subject lacks, the appraiser:

• a.Subtracts value from the comparable, since adjustments are made to the comparable alone✓
• b.Adds value to the subject, because the subject must be brought up to the comparable's level
• c.Adds value to the comparable, because the feature makes the comparable more desirable
• d.Makes no adjustment, because feature differences are handled in the reconciliation stage

The governing rule is that the appraiser adjusts the comparable, never the subject, because the subject's value is the unknown being solved for. If the comparable is superior, its price is adjusted downward to answer what it would have sold for had it been like the subject. If the comparable is inferior, its price is adjusted upward. Adding value to the subject inverts the method. And reconciliation is the final weighing of indicated values from the several approaches, which happens after adjustments, not instead of them.

A comparable sold for $600,000. It has a pool worth $20,000 that the subject lacks, and the subject has an extra bedroom worth $30,000 that the comparable lacks. The adjusted indicated value of the subject is:

• a.$590,000
• b.$650,000
• c.$610,000✓
• d.$550,000

Adjust the comparable, not the subject. The comparable is superior by a $20,000 pool, so subtract $20,000. The comparable is inferior by a bedroom worth $30,000, so add $30,000. Starting at $600,000 gives $600,000 minus $20,000 plus $30,000, or $610,000. Adding both amounts gives $650,000 and adjusting in the wrong direction on both gives $590,000, each of which reverses one or both signs. The figure $550,000 subtracts both differences. The arithmetic is simple by design; the discipline is in the direction of each adjustment, not in the sums.

Which approach to value would an appraiser weight most heavily in valuing a newly built public library?

• a.The gross rent multiplier method, because it converts rent into value with a single factor
• b.The sales comparison approach, because recent sales are the best evidence of market behavior
• c.The income approach, because the building generates measurable benefits to the community
• d.The cost approach, because there are few comparable sales and no income stream to capitalize✓

The cost approach is most persuasive for new or special-purpose improvements: a library is rarely sold, so there are no meaningful comparables, and it produces no rent to capitalize. Because the improvement is new, accrued depreciation is minimal, which is the condition in which the cost approach is at its strongest. The sales comparison approach fails for want of comparables. The income approach needs a market-derived income stream, which community benefit is not. And a gross rent multiplier is a screening device for small rental properties.

In the cost approach, which form of depreciation is by definition incurable and originates outside the property boundary?

• a.Physical deterioration, such as a worn roof covering nearing the end of its life
• b.External obsolescence, such as a new freeway interchange built next to the parcel✓
• c.Functional obsolescence, such as a four-bedroom house with a single bathroom
• d.Accrued depreciation, being the total loss in value from all causes combined

External obsolescence, also called economic obsolescence, is caused by influences outside the property such as traffic, a change in the neighborhood, or a downturn in the local economy, and because the owner cannot fix what lies off the parcel it is treated as incurable. Physical deterioration is wear and tear and is often curable by repair. Functional obsolescence arises from a defect in the design or utility of the improvement itself and may be curable or incurable. Accrued depreciation is the umbrella term for the total loss in value from all three causes.

An income property produces a net operating income of $60,000. Investors in that market require a 6 percent capitalization rate. Using the income approach the indicated value is:

• a.$360,000
• b.$1,000,000✓
• c.$100,000
• d.$3,600,000

In direct capitalization, value equals net operating income divided by the capitalization rate. Dividing $60,000 by 0.06 gives $1,000,000. Multiplying instead of dividing gives $60,000 times 0.06, or $3,600, which is not among the choices; the $360,000 and $3,600,000 options are that same multiplication done after misreading the 6 percent rate as 6 or as 60. Dividing $60,000 by 0.6 gives $100,000. Committing the relationship to memory in all three forms, so that rate equals income divided by value and income equals value times rate, lets a candidate solve any of the three variants.

Holding net operating income constant, an increase in the capitalization rate an investor demands will:

• a.Decrease the indicated value, because value is income divided by the rate✓
• b.Increase the indicated value, because a higher rate signals a stronger income stream
• c.Leave value unchanged, because the rate affects only the loan the buyer can obtain
• d.Increase the net operating income, because expenses are capitalized at the same rate

Because value equals net operating income divided by the capitalization rate, the rate sits in the denominator and moves value in the opposite direction. A rate rising from 5 percent to 8 percent on the same income cuts the indicated value substantially, which is why rising required yields depress income property values. A higher rate signals greater perceived risk or a higher alternative return, not a stronger income stream. The rate is a valuation input rather than a financing term. And net operating income is derived from the property's own revenues and expenses, so capitalization does not change it.

A four-unit building rents for $4,000 a month and similar buildings in the area sell at a gross rent multiplier of 150. The indicated value is:

• a.$60,000
• b.$600,000✓
• c.$26,700
• d.$4,000,000

A gross rent multiplier stated against monthly rent is applied by multiplying the monthly gross rent by the multiplier, so $4,000 times 150 gives $600,000. Dividing the rent by the multiplier gives about $26.70, and the $26,700 option is that same quotient with the decimal shifted three places; dividing the multiplier by the rent gives 0.0375, which measures nothing here. The key caution is that a multiplier drawn from monthly rents must be applied to monthly rents and one drawn from annual rents to annual rents; mixing them shifts the answer by a factor of twelve. Because it ignores expenses and vacancy, a multiplier screens rather than replaces capitalization.

Which sequence correctly states the steps of the cost approach?

• a.Estimate land value, add the replacement cost of improvements, then subtract accrued depreciation✓
• b.Estimate the reproduction cost, subtract land value, then add accrued depreciation to the remainder
• c.Capitalize the net operating income, subtract the mortgage balance, then add the land value
• d.Average the three most recent comparable sales, then adjust the average for market conditions

The cost approach estimates the value of the site as if vacant and available for its highest and best use, adds the current cost to reproduce or replace the improvements, and subtracts all accrued depreciation from that cost. Land is added, never subtracted, because land is not depreciated in this method. Capitalizing income and deducting a mortgage describes an equity valuation exercise rather than the cost approach. And averaging comparable sales without adjusting each one for its differences from the subject abandons the discipline that makes the sales comparison approach reliable.

Reproduction cost differs from replacement cost in that reproduction cost estimates the cost to build:

• a.A structure of equal utility using current materials, standards and design
• b.An exact duplicate of the improvement, outdated features included✓
• c.Only the portion of the improvement that has not yet suffered physical deterioration
• d.The improvement at the price level prevailing on the date the original permit was issued

Reproduction cost is the cost to construct an exact replica of the subject improvement using the same or closely similar materials, carrying forward whatever superadequacies or outdated features it has. Replacement cost is the cost to build a structure of equivalent utility using current materials, standards and design, so it already removes some functional obsolescence. Neither concept limits itself to the undeteriorated portion, since depreciation is deducted afterward. And both are measured at current cost levels on the effective date of the appraisal, not at historical prices.

An appraiser weighs the indicated values from the three approaches and forms a single conclusion. This final step is called:

• a.Capitalization, in which the strongest indication is converted into a rate of return
• b.Averaging, in which the three indications are added together and divided by three
• c.Reconciliation, in which the approaches are weighted by their reliability✓
• d.Amortization, in which the value indications are spread across the remaining economic life

Reconciliation is the appraiser's analysis of the strengths and weaknesses of each approach in light of the property type, the assignment and the quality of the data, producing a single value opinion. It is expressly not an average: mechanically averaging a weak indication with a strong one imports the weakness. Capitalization converts income into value and belongs inside the income approach. Amortization is the systematic repayment of a loan over time and is a finance concept, not a step in the appraisal process.

For a single-family residence in an established California tract, an appraiser will normally give the greatest weight to:

• a.The sales comparison approach, because ample arm's length sales of similar homes exist✓
• b.The cost approach, because construction costs are the most objective data available
• c.The income approach, because the home could be rented at prevailing market rents
• d.The gross rent multiplier, because it is simpler than a full capitalization analysis

Owner-occupied houses in an established tract trade frequently, so the sales comparison approach rests on abundant arm's length evidence of what buyers actually pay and is the primary approach for that property type. The cost approach is undermined by the difficulty of measuring accrued depreciation in an older home and by the fact that buyers of houses do not think in construction cost terms. The income approach fits properties bought for their income, which a family residence generally is not. And a gross rent multiplier is a rough screening tool for small rental property.

Which situation would most likely disqualify a recent sale from use as a comparable in an appraisal?

• a.The buyer paid all cash rather than obtaining conventional financing
• b.The sale closed eleven weeks before the effective date of the appraisal
• c.The sale was between a parent and child at a price set for family reasons✓
• d.The property is two blocks farther from the school than the subject property

Market value assumes a transaction between parties acting prudently and knowledgeably in their own interest, so a sale between related parties at a price set for family reasons is not an arm's length transaction and cannot support a market value conclusion without heavy qualification. A sale eleven weeks old is recent enough to use, adjusted for any change in market conditions. An all-cash purchase is a financing characteristic that may call for a small adjustment rather than exclusion. And a two-block location difference is exactly the kind of variance a location adjustment handles.

Net operating income for an income property is computed as:

• a.Cash flow before taxes plus the principal portion of the annual mortgage payment
• b.Effective gross income less operating expenses and less the annual mortgage payment
• c.Potential gross income less vacancy, operating expenses, depreciation and income tax
• d.Effective gross income less operating expenses, before debt service and income tax✓

Net operating income is effective gross income minus operating expenses, and it is deliberately calculated before debt service, income tax and depreciation. That is what makes it comparable across properties financed differently: two identical buildings produce the same net operating income whether one is free and clear and the other heavily leveraged. Subtracting the mortgage payment produces cash flow before taxes, a different figure. Depreciation and income tax are owner-specific and are excluded. And adding back a principal component confuses a financing item with an operating one.

Which expense is properly excluded from operating expenses when computing net operating income?

• a.The property management fee paid to a licensed California property manager
• b.The annual premium for the property's hazard and liability insurance coverage
• c.The interest and principal paid on the deed of trust encumbering the property✓
• d.The recurring cost of routine repairs and maintenance of the common areas

Debt service is a financing cost belonging to the owner rather than to the property, so it is excluded from operating expenses and deducted only after net operating income to arrive at cash flow. Hazard and liability insurance, management fees and routine repairs and maintenance are all ordinary operating expenses necessary to keep the property producing income, and each is deducted in arriving at net operating income. Capital improvements and income taxes are likewise excluded, for the same reason: they do not measure the property's own operating performance.

An investor pays $200,000 cash toward a building and receives $16,000 of pre-tax cash flow in the first year. The cash-on-cash return is:

• a.12.5 percent
• b.8 percent✓
• c.16 percent
• d.1.25 percent

Cash-on-cash return divides the annual pre-tax cash flow by the cash actually invested, so $16,000 divided by $200,000 gives 0.08, or 8 percent. Dividing the investment by the cash flow gives 12.5, which is a multiplier rather than a return. The figure 16 percent would result from using a $100,000 investment. And 1.25 percent misplaces the decimal. Cash-on-cash differs from the capitalization rate because it is measured against the equity the investor put in rather than against the total value of the property.

Positive leverage exists when an investor uses borrowed money and:

• a.The property's assessed value is lower than the price the investor paid
• b.The loan-to-value ratio is below 50 percent of the purchase price
• c.The loan carries a fixed rate rather than an adjustable rate of interest
• d.The property's rate of return exceeds the cost of the borrowed funds✓

Leverage is positive when the property earns a higher return than the interest cost of the debt used to buy it, so borrowing magnifies the return on the investor's own equity. When the cost of the debt exceeds the property's return, leverage is negative and borrowing reduces the equity return. The loan-to-value ratio measures how much debt is used, not whether it pays to use it. Whether the rate is fixed or adjustable affects risk rather than the sign of the leverage. And the relationship between assessed and market value is a property tax matter.

Under Proposition 13, when a California buyer purchases a home, the property's assessed value is normally:

• a.Carried over from the seller unchanged, so the buyer inherits the seller's old tax bill
• b.Reset to the purchase price as a new base year value for the buyer✓
• c.Set at half of the purchase price for the first four years of the buyer's ownership
• d.Determined each year by a fresh market appraisal performed by the county assessor

A change in ownership is a reassessment event under Proposition 13, so the property is assessed at full cash value, ordinarily the purchase price, which becomes the new base year value; annual increases are then capped at 2 percent. That is why a buyer should be warned that the tax bill will not resemble the long-time seller's. Assessed value carries over only where an exclusion applies, such as certain transfers between spouses or a qualifying base year value transfer under Proposition 19. There is no half-value phase-in, and annual market revaluation is what Proposition 13 abolished.

An investor exchanges an apartment building for another investment property and defers the gain under Internal Revenue Code section 1031. Which condition must be satisfied?

• a.Both properties must be encumbered by loans from the same institutional lender
• b.Both properties must be located within the boundaries of the State of California
• c.Both properties must produce identical annual net operating income figures
• d.Both properties must be held for productive use in a business or for investment✓

A section 1031 exchange defers gain when property held for productive use in a trade or business or for investment is exchanged for like-kind property held for the same purposes. A personal residence does not qualify. Like-kind is read broadly for real property, so an apartment building may be exchanged for raw land or a commercial building, and the properties need not be in the same state. There is no requirement that the incomes match. And the identity of the lender is irrelevant, although differences in debt relief can create taxable boot.

A California income property has potential gross income of $120,000, a vacancy and collection loss of $12,000, and operating expenses of $48,000. Its net operating income is:

• a.$108,000
• b.$72,000
• c.$60,000✓
• d.$180,000

Deduct the vacancy and collection loss from potential gross income to get effective gross income of $108,000, then deduct operating expenses of $48,000 to reach a net operating income of $60,000. The figure $108,000 is effective gross income, which is the intermediate step rather than the answer. The figure $72,000 results from deducting expenses but forgetting vacancy. And $180,000 adds the figures instead of subtracting them. Keeping the ladder in order — potential gross, effective gross, net operating, then cash flow — prevents most errors on this kind of item.

For an investor who owns California residential rental property, cost recovery, commonly called depreciation, may be taken on:

• a.The land and improvements together, allocated in proportion to the county assessment
• b.The land only, because land is the component that loses value as the area develops
• c.The improvements only, because land is not depreciable for federal income tax purposes✓
• d.Neither, because residential rental property is excluded from cost recovery entirely

Federal tax law allows cost recovery on the depreciable improvements but not on land, which is treated as having an indefinite life, so the purchase price must be allocated between the two. Because a larger improvement allocation produces a larger annual deduction, the allocation is a point of genuine consequence to an investor. Land is never depreciable, so neither a land-only nor a combined approach is correct. And residential rental property is squarely depreciable, over a recovery period longer than that used for equipment and shorter than that for nonresidential real property.