The subject property has annual effective gross income, after vacancy and collection loss, of $120,000. All annual property operating expenses total $45,000 and exclude debt service. At an 8.5% overall capitalization rate, what value is indicated, rounded to the nearest dollar?
Correct Answer
B) $882,353
(120000−45000)÷0.085 = 882352.94. Common errors: capitalizing EGI instead of NOI gives $1,411,765; adding the expenses instead of deducting them gives $1,941,176; misplacing the decimal in the 8.5% rate gives $88,235.
Why This Is the Correct Answer
Option B is correct because NOI is $120,000 - $45,000 = $75,000, and $75,000 / 0.085 = $882,352.94, which rounds to $882,353. Direct capitalization divides NOI, not EGI, by the overall rate. Debt service is already excluded from expenses, as it should be.
Why the Other Options Are Wrong
Option A: $88,235
Option A is wrong because $88,235 comes from misplacing the decimal in the 8.5% rate: $75,000 / 0.85 = $88,235. The rate is 0.085, so the correct value is $75,000 / 0.085 = $882,353.
Option C: $1,411,765
Option C is wrong because $1,411,765 comes from capitalizing EGI instead of NOI: $120,000 / 0.085 = $1,411,765. Expenses must be deducted first, giving ($120,000 - $45,000) / 0.085 = $882,353.
Option D: $1,941,176
Option D is wrong because $1,941,176 comes from adding the expenses instead of deducting them: ($120,000 + $45,000) / 0.085 = $1,941,176. The correct value is ($120,000 - $45,000) / 0.085 = $882,353.
IRV: Income over Rate
Value equals Income divided by Rate, and the income in direct capitalization is NOI.
How to use: Use IRV after you have reduced EGI to NOI by subtracting operating expenses.
Exam Tip
Before dividing by the rate, confirm you are working with NOI. Also convert the percentage rate carefully to a decimal.
Common Mistakes to Avoid
- -Capitalizing EGI instead of NOI
- -Converting 8.5% to 0.85
- -Including debt service in operating expenses
Concept Deep Dive
Analysis
This question tests direct capitalization from EGI. NOI is EGI less operating expenses, and value is NOI divided by the overall capitalization rate. Here ($120,000 - $45,000) / 0.085 gives about $882,353.
Background Knowledge
The income processing sequence runs from potential gross income, less vacancy and collection loss, to effective gross income, less operating expenses, to net operating income. Direct capitalization converts one year's NOI to value by dividing by an overall capitalization rate. Expenses and the rate must use compatible conventions.
Real-World Application
An appraiser values a small office building with EGI of $120,000 and stabilized expenses of $45,000. Using an 8.5% overall rate supported by comparable sales, the appraiser capitalizes the $75,000 NOI to about $882,000.
More Income Approach Questions
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Which two depreciation categories may each be classified as curable or incurable by comparing the cost to remedy a deficiency with the value gained?
Improvement cost new is $800,000. Separately supported improvement depreciation deductions of $120,000, $80,000, $40,000 are expressly nonoverlapping and not already excluded from cost new. No site is included. What depreciated improvement amount results?
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Which highest-and-best-use criterion addresses whether a proposed use is allowed by zoning and applicable legal restrictions?
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When reconciling value indications from the three approaches to value, an appraiser should:
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