A property generates $120,000 in gross income with operating expenses of $45,000. Using a capitalization rate of 8.5%, what is the indicated value?
Correct Answer
A) $882,353
Why this is correct: First, calculate Net Operating Income (NOI): Gross Income ($120,000) minus Operating Expenses ($45,000) equals $75,000. Then, apply direct capitalization: Value = NOI ÷ Cap Rate, so $75,000 ÷ 0.085 = $882,353. Why the other choices are wrong: "$750,000" results from dividing gross income by the cap rate ($120,000 ÷ 0.085). "$1,411,765" comes from dividing expenses by the cap rate ($45,000 ÷ 0.085). "$1,058,824" uses an incorrect cap rate of 7.08% ($75,000 ÷ $1,058,824). Exam tip: Remember the sequence: NOI first, then divide by the cap rate. Never capitalize gross income.
Why This Is the Correct Answer
Option A correctly applies the two-step direct capitalization process. First, NOI is calculated by subtracting operating expenses ($45,000) from gross income ($120,000), yielding $75,000. Then, the direct capitalization formula (Value = NOI ÷ Cap Rate) is applied: $75,000 ÷ 0.085 = $882,353. This follows the standard income approach methodology where NOI represents the property's earning capacity available to the owner after all operating expenses.
Why the Other Options Are Wrong
NOI-CAP Division Rule
Remember 'NOI over CAP' - Net Operating Income goes on top, Capitalization rate goes on bottom. Think 'NO-CAP' = NOI ÷ CAP. Also remember: Gross minus Operating expenses = NOI (GO-NOI).
How to use: When you see gross income, operating expenses, and a cap rate, immediately think 'GO-NOI' then 'NO-CAP': subtract expenses from gross income first, then divide that result by the cap rate.
Exam Tip
Always calculate NOI first before applying the cap rate - never use gross income directly in the capitalization formula. Double-check your division by ensuring the cap rate is in decimal form (8.5% = 0.085).
Common Mistakes to Avoid
- -Using gross income instead of NOI in the capitalization formula
- -Forgetting to convert the cap rate percentage to decimal form
- -Adding back operating expenses instead of subtracting them from gross income
Concept Deep Dive
Analysis
This question tests the fundamental income approach concept of direct capitalization, which is one of the three primary methods used to value income-producing properties. Direct capitalization converts a single year's net operating income (NOI) into an estimate of market value by dividing NOI by an appropriate capitalization rate. The process requires first calculating NOI by subtracting operating expenses from gross income, then applying the capitalization formula. This method assumes that the property's income and expenses are stabilized and representative of typical market performance.
Background Knowledge
Direct capitalization is a income approach method that converts NOI into market value using the formula: Value = NOI ÷ Capitalization Rate. NOI represents the income remaining after deducting all operating expenses from gross income, but before debt service and income taxes.
Real-World Application
Appraisers use direct capitalization daily when valuing rental properties, office buildings, and retail centers. They analyze comparable sales to extract cap rates from the market, then apply these rates to the subject property's stabilized NOI to estimate value.
More Income Approach Questions
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