A broker advertises the recent $950,000 cash sale of a 10-unit apartment building at a 9% capitalization rate, based on pro forma NOI of $85,500. While verifying the sale, an appraiser learns that the pro forma omitted vacancy and collection loss of $5,700 and a market management fee of $3,800. The buyer's partnership also pays $5,700 a year for its own accounting. What overall rate does this sale indicate?
Correct Answer
B) 8.00%
Supported NOI is $85,500 − $5,700 − $3,800 = $76,000, and $76,000 ÷ $950,000 = 8.00%. Taking the advertised figure gives 9.00%, and deducting vacancy but not management gives 8.40%. Also deducting the partnership accounting fee gives 7.40%, but that fee is a cost of the owner's entity and is not needed to operate the property.
Why This Is the Correct Answer
Option B is correct because supported NOI is $85,500 − $5,700 − $3,800 = $76,000, and $76,000 ÷ $950,000 = 8.00%. Vacancy and collection loss and market management are real parts of a supported income estimate. The partnership accounting fee is left out because it is not necessary to maintain the property or produce its income.
Why the Other Options Are Wrong
Option A: 7.40%
Option A, 7.40%, deducts the partnership fee as well: $76,000 − $5,700 = $70,300, and $70,300 ÷ $950,000 = 7.40%. That fee is a cost of the buyer's ownership entity rather than a property operating expense, so the correct rate is $76,000 ÷ $950,000 = 8.00%.
Option C: 8.40%
Option C, 8.40%, corrects for vacancy but leaves out management: $85,500 − $5,700 = $79,800, and $79,800 ÷ $950,000 = 8.40%. A market management fee belongs in a supported NOI, so the correct rate is $76,000 ÷ $950,000 = 8.00%.
Option D: 9.00%
Option D, 9.00%, accepts the advertisement: $85,500 ÷ $950,000 = 9.00%. Verification shows that pro forma income is overstated, so the correct rate is $76,000 ÷ $950,000 = 8.00%.
Verify before you divide
An advertised cap rate is a claim, not data. Fix the income first, then calculate the rate yourself.
How to use: Use this habit whenever a problem quotes a broker's or seller's cap rate.
Exam Tip
If a problem gives an advertised rate and then corrections, expect the advertised rate to be an option. Recalculate from the verified NOI and test each listed cost to see whether the property needs it to operate.
Common Mistakes to Avoid
- -Accepting a marketing cap rate with no income verification
- -Correcting for vacancy but ignoring a market management fee
- -Treating an owner-entity cost as a property operating expense
Concept Deep Dive
Analysis
The skill tested is the numerator of an extracted rate. An advertised cap rate is only as good as the income behind it, so the appraiser verifies that income and corrects it before relying on the rate. The task is to make the two needed corrections and to reject a cost that belongs to the owner's entity rather than to the property.
Background Knowledge
Published or advertised capitalization rates may rest on optimistic assumptions or inconsistent definitions of income. Appraisers verify the income behind a sale so that extracted rates reflect a supported NOI on a consistent basis. Operating expenses are those needed to maintain the property and continue producing income, which excludes costs specific to an owner's legal or tax structure.
Real-World Application
A sales flyer for a recent closing touts a high cap rate that would make the appraiser's subject look underpriced. A call to the buyer reveals the flyer ignored vacancy and management. After correcting the income, the appraiser extracts a noticeably lower rate and records the source of the correction in the workfile.
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?
People Also Study
Real Estate Market
13.6% of exam
Property Description
11.8% of exam
Land or Site Valuation
4.5% of exam
Sales Comparison Approach
16.4% of exam
Cost Approach
13.6% of exam
Previous Question
The subject property is a fourplex with annual NOI of $42,000. A similar fourplex recently sold for $650,000 with below-market seller financing. The appraiser estimates its cash-equivalent price at $600,000, and its annual NOI is $48,000. What is the indicated value of the subject by direct capitalization?
Next Question
An appraiser is developing a stabilized rental income model to value the fee simple interest in a leased property. Contract rent is $1,100 and market rent is $1,275. Which rent is the appropriate base for the model?