A broker reports the $2,160,000 cash-equivalent sale of a small retail building with “net income” of $118,800. Verification shows that this figure is after $54,000 of annual debt service on the seller’s loan. The subject property is a similar retail building with annual NOI of $156,000. What is the subject’s indicated value by direct capitalization?
Correct Answer
A) $1,950,000
Debt service comes after net operating income, so the comparable's NOI is $118,800 + $54,000 = $172,800, the rate is $172,800 ÷ $2,160,000 = 8%, and the subject's value is $156,000 ÷ 0.08 = $1,950,000. Using the broker's figure as reported gives a 5.5% rate and $2,836,364. Adding the $54,000 to the subject's income as well gives $2,625,000, but the subject's NOI is already before debt service. The figure of $2,160,000 is the comparable's price, unadjusted for income.
Why This Is the Correct Answer
Option A is correct because debt service is paid out of net operating income, so it must be added back: $118,800 + $54,000 = $172,800. The extracted rate is $172,800 ÷ $2,160,000 = 8%, and $156,000 ÷ 0.08 = $1,950,000.
Why the Other Options Are Wrong
Option B: $2,160,000
Option B, $2,160,000, is the comparable's sale price. It does not reflect the subject's income; the correct indication is $156,000 ÷ 0.08 = $1,950,000.
Option C: $2,625,000
Option C, $2,625,000, corrects the rate to 8% but also adds the debt service to the subject: ($156,000 + $54,000) ÷ 0.08 = $2,625,000. The subject's $156,000 is already before debt service, so the correct value is $156,000 ÷ 0.08 = $1,950,000.
Option D: $2,836,364
Option D, $2,836,364, uses the broker's figure as reported: $118,800 ÷ $2,160,000 = 5.5%, and $156,000 ÷ 0.055 = $2,836,364. That mixes after-financing income in the rate with before-financing income in the subject; the correct value is $156,000 ÷ 0.08 = $1,950,000.
Debt Comes After NOI
Think of the statement as a staircase: income, losses, expenses, NOI, and only then debt service. Anything taken below NOI must be added back before extracting a rate.
How to use: Use the staircase whenever a sale's net income figure might already reflect the buyer's or seller's loan.
Exam Tip
Treat the label on a reported income figure as a claim to check. If a comparable's reported income is after debt service, correct it before dividing.
Common Mistakes to Avoid
- -Treating cash flow after debt service as NOI
- -Correcting the comparable and also changing the subject's already-correct NOI
- -Accepting a broker's income label without verification
Concept Deep Dive
Analysis
A rate is reliable only if the income in it is the same kind as the income it will capitalize. Here the reported figure is really cash flow after financing, not NOI. Adding debt service back restores the property-level income, which then matches the subject's NOI.
Background Knowledge
NOI measures property income before financing, and cash flow to equity is what remains after debt service. Loose labels such as net income can refer to either one, so reported figures need verifying before they are used in a rate.
Real-World Application
A broker's sale flyer shows a modest net income figure that implies a low rate. On verification the appraiser finds the figure was after mortgage payments, restates it to NOI and gets a rate in line with other sales.
More Income Approach Questions
Which model describes yield capitalization of property benefits?
An appraiser is valuing a duplex. A market survey of recent duplex sales reports prices at 10.8 times potential gross income, with stabilized vacancy and credit loss of 10% of PGI and no other income. The subject's rent schedule is unavailable, but the property manager's records show collected income of $54,000 a year, in line with market rent and the 10% market loss. What value is indicated?
The subject property is a fourplex with annual EGI of $72,000 and operating expenses of $28,800. Of those expenses, $18,000 is fixed and $10,800 varies in direct proportion to EGI. The owner's annual mortgage payments are $21,000. An appraiser projects that EGI will fall 10% because of higher vacancy. What is the projected NOI?
Annual NOI available for debt service is $168,000 and total annual mortgage principal and interest debt service is $120,000. What is NOI ÷ debt service?
Annual PGI is $250,000 and combined vacancy and collection loss is explicitly 12% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $360,000 and combined vacancy and collection loss is explicitly 8% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $640,000. Combined vacancy and collection loss is 6.25% of PGI. There is no other income. What EGI remains?
An appraiser is updating a prior appraisal of a triplex with potential gross income of $60,000 and no other income. The prior appraisal used vacancy and credit loss of 5% of PGI, and a new survey of competing rentals indicates 8%. The operating expenses of $24,000 are property taxes, insurance and contract services that do not vary with occupancy, and the market overall rate remains 7.5%. By what percentages do effective gross income and indicated value decrease?
Annual potential rental income is $600,000 and vacancy loss alone is $36,000. What percentage of potential rent does that loss represent?
In the subject's market, lenders on fourplexes have lowered their typical loan-to-value ratio from 70% to 60%. The annual mortgage constant remains 5% and the equity dividend rate remains 10%. The subject's NOI has not changed. How does this affect the overall rate indicated by the band of investment and the indicated value?
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Previous Question
A property has annual effective gross income of $520,000 and an operating expense ratio of 28% of EGI. Market data indicate an overall capitalization rate of 7.5%. What value is indicated by direct capitalization, to the nearest dollar?
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Year 11 NOI is projected at $385,000. Capitalize it at 7% to estimate a gross sale at the end of year 10. There are no selling costs. Discount that single reversion for 10 years at 8.5% annually. What is its present value, rounded to the nearest dollar?