A ground lease pays the leased-fee owner a stabilized annual net contract rent of $60,000; market ground rent for the site would be $66,000 a year. A market-supported 6% direct capitalization rate is appropriate for the contract income and the leased-fee interest, including the lease terms. What leased-fee value does direct capitalization indicate?
Correct Answer
C) $1,000,000
Direct capitalization gives $60,000/0.06 = $1,000,000 when the stated income is the stabilized net contract rent to the leased-fee interest and the rate is appropriate for that income and interest. Capitalizing the $66,000 market rent ($1,100,000) ignores that the leased-fee owner receives the contract rent, and capitalizing only the $6,000 rent gap ($100,000) does not value the leased fee. Actual ground leases may require analysis of remaining term, reversion, expenses and contract-versus-market rent.
Why This Is the Correct Answer
Option C is correct because direct capitalization converts one year's income to value by dividing by the capitalization rate: $60,000 / 0.06 = $1,000,000. The stem states the income is stabilized net income to the leased-fee owner and the 6% rate is appropriate for that interest and lease terms. Ground rent capitalization is a form of direct capitalization in the income approach.
Why the Other Options Are Wrong
Option A: $100,000
Option A, $100,000, capitalizes only the $6,000 gap between market and contract rent: $6,000 / 0.06 = $100,000. That gap is not the leased-fee owner's income; the leased fee is valued from the $60,000 contract rent: $60,000 / 0.06 = $1,000,000.
Option B: $360,000
Option B, $360,000, multiplies the income by 6 as a whole number: $60,000 x 6 = $360,000. Direct capitalization divides by the decimal rate: $60,000 / 0.06 = $1,000,000.
Option D: $1,100,000
Option D, $1,100,000, capitalizes the $66,000 market rent: $66,000 / 0.06 = $1,100,000. The leased-fee owner receives the $60,000 contract rent, and the 6% rate is stated for that income, so the indication is $60,000 / 0.06 = $1,000,000.
IRV: Income over Rate is Value
Picture I on top of R in a fraction: V = I / R. Covering the letter you want shows the formula for the other two.
How to use: Use this to set up any direct capitalization problem before plugging in numbers.
Exam Tip
Convert the percentage to a decimal and divide; at a 6% rate the value should be about 16.7 times the income, which is a quick check on your answer.
Common Mistakes to Avoid
- -Multiplying the income by the whole-number percentage
- -Capitalizing market rent instead of the contract rent the leased-fee owner receives
- -Capitalizing only the difference between market and contract rent
Concept Deep Dive
Analysis
This question tests direct capitalization of ground rent for the leased-fee interest. The leased-fee owner receives the $60,000 contract rent, and the 6% rate is stated for that income and interest, so value equals income divided by rate (V = I / R). Do not substitute the market rent or the rent gap, and convert 6% to 0.06 before dividing.
Background Knowledge
Direct capitalization divides a single year's income by an overall capitalization rate, or multiplies it by an income multiplier, to indicate value. For a ground lease, the income and rate must match the interest being valued; real assignments may also need analysis of remaining term, reversion, expenses and contract versus market rent.
Real-World Application
An appraiser values the land owner's interest in a parcel leased to a restaurant operator under a long-term ground lease. After confirming the net ground rent is stabilized and finding a market-supported rate for similar leased-fee land interests, the appraiser divides the rent by that rate.
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