A property generates $120,000 in Net Operating Income and has a capitalization rate of 8%. What is the indicated value using the income approach?
Correct Answer
C) $1,500,000
Why this is correct: The basic income capitalization formula is Value = NOI ÷ Cap Rate. Here, $120,000 ÷ 0.08 = $1,500,000. Why the other choices are wrong: $960,000 results from multiplying NOI by the cap rate ($120,000 × 0.08). $1,200,000 uses a 10% cap rate ($120,000 ÷ 0.10). $1,800,000 uses a 6.67% cap rate ($120,000 ÷ 0.0667). Exam tip: Double-check your math: Dividing by 0.08 is the same as multiplying by 12.5. $120,000 × 12.5 = $1,500,000.
Why This Is the Correct Answer
Option B is correct because it properly applies the income capitalization formula: Value = NOI ÷ Cap Rate. Substituting the given values: Value = $120,000 ÷ 0.08 = $1,500,000. This calculation converts the decimal cap rate (0.08) correctly and performs the division accurately. The formula essentially asks 'what amount of money, when multiplied by 8%, would produce $120,000 in annual income?'
Why the Other Options Are Wrong
Option A: $960,000
Option A ($960,000) appears to result from using an incorrect cap rate in the calculation, possibly using 0.125 (12.5%) instead of 0.08 (8%), or from another computational error in the division process.
Option B: $1,200,000
Option B ($1,200,000) results from incorrectly multiplying NOI by the cap rate ($120,000 × 0.08 = $9,600) or using the wrong formula entirely, possibly confusing this with a different calculation.
Option D: $1,800,000
Option D ($1,800,000) suggests using an incorrect cap rate of approximately 0.067 (6.7%) instead of the given 8%, or possibly adding an extra step or factor that shouldn't be included in the basic capitalization formula.
NOI Divided by Cap = Value Pride
Remember 'NOI over Cap gives you the MAP' - NOI over Cap rate gives you the Market value, Asset value, Property value. Visualize NOI sitting on top of Cap rate in a fraction, with Value as the result.
How to use: When you see NOI and cap rate given, immediately set up the fraction NOI/Cap Rate. Convert the percentage to decimal (8% = 0.08) and divide. The word 'over' in the mnemonic reminds you it's division, not multiplication.
Exam Tip
Always convert percentage cap rates to decimals before calculating (8% = 0.08). Double-check by working backwards: multiply your answer by the cap rate to see if you get back to the original NOI.
Common Mistakes to Avoid
- -Multiplying NOI by cap rate instead of dividing
- -Forgetting to convert percentage cap rate to decimal form
- -Using gross income instead of net operating income in the calculation
Concept Deep Dive
Analysis
This question tests the fundamental income capitalization formula, which is one of the three primary approaches to real estate valuation. The income approach converts a property's net operating income into an estimate of value by applying a capitalization rate that reflects the relationship between income and value for similar properties. This approach is particularly important for income-producing properties like rental buildings, office complexes, and retail centers. The capitalization rate represents the rate of return an investor would expect from the property, and it's derived from market data of comparable sales.
Background Knowledge
The income approach is based on the principle of anticipation, which states that value is created by the expectation of future benefits. The capitalization rate is derived from market data and represents the relationship between a property's net operating income and its sale price, expressed as a percentage.
Real-World Application
Appraisers use this formula daily when valuing rental properties, office buildings, and shopping centers. They gather rental income data, subtract operating expenses to get NOI, then research recent sales to extract appropriate cap rates for similar properties in the market.
More Income Approach Questions
A building cost $2,500,000 to construct 8 years ago. Using straight-line depreciation over a 40-year life, what is the current depreciated value?
The following sale prices were recorded: $245,000, $250,000, $250,000, $255,000, $280,000. What is the mode?
A property has a replacement cost of $1,800,000. Physical deterioration is estimated at $200,000, functional obsolescence at $150,000, and external obsolescence at $100,000. What is the depreciated value using the breakdown method?
What is the present value of $150,000 to be received in 5 years, assuming a discount rate of 8%?
A triangular lot has a base of 100 feet and a height of 80 feet. What is the area in square feet?
An irregular lot can be divided into a rectangle (100' × 80') and a triangle (base 60', height 40'). What is the total area in acres?
A property has a net operating income of $85,000 and annual debt service of $68,000. What is the debt coverage ratio?
A warehouse has interior dimensions of 120 feet × 80 feet × 20 feet high. What is the volume in cubic feet?
A property is purchased for $500,000 with a loan of $400,000. What is the loan-to-value ratio?
A property sold for $400,000 with annual gross rent of $40,000. What is the gross rent multiplier?
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