A property generates $120,000 in net operating income and is valued at $1,500,000. What is the capitalization rate?
Correct Answer
A) 8.0%
Capitalization rate = NOI ÷ Value. $120,000 ÷ $1,500,000 = 0.08 or 8.0%.
Why This Is the Correct Answer
Option A is correct because the capitalization rate formula is NOI divided by Value. When we calculate $120,000 ÷ $1,500,000, we get 0.08, which converts to 8.0%. This straightforward division gives us the rate of return that the property's net operating income represents relative to its total value. The 8.0% cap rate indicates that the property generates an 8% annual return based on its current market value and operating income.
Why the Other Options Are Wrong
Option B: 12.5%
Option B (12.5%) would result from incorrectly dividing the smaller number by a portion of the larger number, or from a calculation error. This rate is too high for the given NOI and value relationship.
Option C: 6.25%
Option C (6.25%) appears to result from inverting part of the calculation or making an arithmetic error. This would occur if someone incorrectly manipulated the NOI and value figures in the formula.
Option D: 10.0%
Option D (10.0%) might result from rounding errors or incorrect decimal placement during calculation. While close to the correct answer, it represents a significant difference in cap rate terms.
NOI Over Value (NOV)
Remember 'NOV' - NOI Over Value = Cap Rate. Think 'November' to remember NOI goes on top (numerator) and Value goes on bottom (denominator).
How to use: When you see a cap rate calculation question, immediately think 'NOV' and set up the fraction with NOI on top and Value on bottom, then divide to get your percentage.
Exam Tip
Always double-check your decimal placement when converting to percentage - 0.08 becomes 8.0%, not 0.8% or 80%.
Common Mistakes to Avoid
- -Inverting the formula (Value ÷ NOI instead of NOI ÷ Value)
- -Incorrect decimal to percentage conversion
- -Using gross income instead of net operating income
Concept Deep Dive
Analysis
This question tests the fundamental income approach concept of capitalization rate, which is the relationship between a property's net operating income and its market value. The capitalization rate (cap rate) is one of the most important metrics in real estate valuation, representing the rate of return an investor would expect from a property based on its income-producing capability. Understanding this formula is crucial because it's used both to value properties (when NOI and cap rate are known) and to analyze investment returns (when NOI and value are known). The cap rate reflects market conditions, property risk, and investor expectations, making it a key indicator of property performance and market trends.
Background Knowledge
The capitalization rate is derived from the income approach to valuation and represents the relationship between net operating income and property value. Students must understand that NOI is the annual income after operating expenses but before debt service and taxes, while the cap rate reflects the rate of return expected by investors in the current market.
Real-World Application
Appraisers use cap rates to compare similar properties and validate market values. If comparable properties in an area are selling at 8% cap rates, a property generating $120,000 NOI should be valued around $1,500,000, making this calculation essential for the sales comparison and income approaches.
More Math & Stats Questions
What is the area of a triangular lot with a base of 120 feet and a height of 80 feet?
An irregular lot has the following measurements: Side A = 100', Side B = 150', Side C = 120', Side D = 180'. If the lot can be divided into two rectangles (100' × 150' and 120' × 30'), what is the total area?
A property has a potential gross income of $180,000, vacancy and collection loss of 7%, and operating expenses of $65,000. What is the NOI?
A building has potential gross income of $180,000, vacancy and collection loss of 8%, and operating expenses of $54,000. What is the net operating income?
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?
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