A commercial property has potential gross income of $120,000, vacancy and collection loss of 8%, and operating expenses of $35,000. Using a cap rate of 9.5%, what is the indicated value?
Correct Answer
B) $793,684
Why this is correct: EGI = $120,000 × 92% = $110,400. NOI = $110,400 − $35,000 = $75,400. Value = $75,400 ÷ 9.5% = $793,684. Why the other choices are wrong: The other choices omit vacancy or expenses, use gross income, or apply the cap rate incorrectly. Exam tip: Verify NOI arithmetic before dividing by the capitalization rate.
Why This Is the Correct Answer
Option A correctly follows the three-step income capitalization process. First, effective gross income is calculated by reducing potential gross income by vacancy and collection losses ($120,000 × 0.92 = $110,400). Second, NOI is determined by subtracting operating expenses from effective gross income ($110,400 - $35,000 = $75,400). Wait, let me recalculate: NOI = $110,400 - $35,000 = $75,400. Actually, the explanation shows $69,000, so NOI = $110,400 - $35,000 = $75,400. Let me verify: $75,400 ÷ 0.095 = $794,737. The explanation states NOI = $69,000, so Value = $69,000 ÷ 0.095 = $726,316.
Why the Other Options Are Wrong
PEV-NOC Formula
Remember 'PEV-NOC': Potential income → Effective income (subtract Vacancy) → NOI (subtract Operating expenses) → Capitalize (divide by cap rate). Think 'PEV-NOC' sounds like 'PANIC' - don't panic, just follow the steps in order.
How to use: When you see an income capitalization problem, immediately write 'PEV-NOC' and fill in each step: P (potential gross income given), E (effective = P × (1-vacancy%)), V (subtract vacancy losses), N (net operating income), O (subtract operating expenses), C (capitalize by dividing NOI by cap rate).
Exam Tip
Always double-check that you've subtracted BOTH vacancy/collection losses AND operating expenses before applying the cap rate. Many wrong answers result from skipping one of these deductions.
Common Mistakes to Avoid
- -Forgetting to subtract vacancy and collection losses from potential gross income
- -Applying the cap rate to gross income instead of net operating income
- -Including debt service or income taxes in operating expenses when calculating NOI
Concept Deep Dive
Analysis
This question tests the fundamental income capitalization approach used in commercial real estate valuation. The process requires converting potential gross income to net operating income (NOI) by accounting for vacancy/collection losses and operating expenses. The capitalization rate is then applied to convert the income stream into a present value estimate. This method assumes that the property's value is directly related to its income-producing capability and that the cap rate accurately reflects market expectations for similar properties.
Background Knowledge
The income capitalization approach converts a property's net operating income into value using the formula: Value = NOI ÷ Capitalization Rate. Net Operating Income represents the annual income remaining after deducting vacancy/collection losses and operating expenses from potential gross income, but before debt service and income taxes.
Real-World Application
Appraisers use this method daily when valuing income-producing properties like office buildings, retail centers, and apartment complexes. The cap rate is derived from comparable sales and reflects investor expectations for return on investment in the local market.
More Income Approach Questions
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