A building has potential gross income of $240,000, vacancy and collection loss of 5%, and operating expenses of $85,000. What is the net operating income (NOI)?
Correct Answer
A) $143,000
NOI = (PGI - Vacancy) - Operating Expenses. Effective Gross Income = $240,000 × 0.95 = $228,000. NOI = $228,000 - $85,000 = $143,000.
Why This Is the Correct Answer
Option A ($143,000) correctly follows the two-step NOI calculation process. First, the Effective Gross Income is calculated by reducing the Potential Gross Income by the vacancy and collection loss: $240,000 × (1 - 0.05) = $228,000. Then, operating expenses are subtracted from the Effective Gross Income to arrive at NOI: $228,000 - $85,000 = $143,000. This represents the actual net income the property generates from operations.
Why the Other Options Are Wrong
Option B: $155,000
Option B ($155,000) incorrectly subtracts the vacancy percentage as a dollar amount rather than calculating the actual vacancy loss, or makes an error in the operating expense deduction calculation.
Option C: $228,000
Option C ($228,000) represents the Effective Gross Income, not the Net Operating Income. This answer fails to subtract the operating expenses from the effective gross income.
Option D: $240,000
Option D ($240,000) represents the Potential Gross Income without any deductions for vacancy, collection losses, or operating expenses, which is not the NOI calculation.
PEG-NO Formula
PEG minus O equals NO: Potential Gross Income becomes Effective Gross Income (PEG) when you subtract vacancy, then subtract Operating expenses (O) to get Net Operating income (NO).
How to use: When you see an NOI question, think 'PEG-NO': first convert Potential to Effective Gross (subtract vacancy), then subtract Operating expenses to get Net Operating income.
Exam Tip
Always perform NOI calculations in the correct sequence: PGI → EGI → NOI. Double-check that you're multiplying vacancy percentages correctly (subtract from 1.00, then multiply by PGI).
Common Mistakes to Avoid
- -Forgetting to subtract vacancy and collection losses before calculating NOI
- -Subtracting vacancy percentage as dollars instead of calculating the actual vacancy amount
- -Stopping at Effective Gross Income without subtracting operating expenses
Concept Deep Dive
Analysis
This question tests the fundamental income approach calculation of Net Operating Income (NOI), which is a critical metric in real estate valuation. NOI represents the actual income a property generates after accounting for vacancy losses and operating expenses, but before debt service and capital expenditures. The calculation requires understanding the sequential flow from Potential Gross Income to Effective Gross Income to Net Operating Income. This is one of the most important calculations in commercial real estate appraisal as NOI is used in capitalization rate calculations to determine property value.
Background Knowledge
Net Operating Income is calculated by starting with Potential Gross Income, subtracting vacancy and collection losses to get Effective Gross Income, then subtracting operating expenses. Operating expenses typically include property taxes, insurance, maintenance, management fees, and utilities, but exclude debt service, depreciation, and capital improvements.
Real-World Application
Appraisers use NOI to determine property values using the income approach by dividing NOI by the capitalization rate. Lenders also use NOI to calculate debt service coverage ratios when underwriting commercial loans.
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