A property generates $120,000 in potential gross income. Vacancy and collection losses are 5%, and operating expenses are $45,000. What is the net operating income?
Correct Answer
B) $69,000
Why this is correct: First, calculate Effective Gross Income (EGI): Potential Gross Income ($120,000) minus Vacancy & Collection Loss (5% of $120,000 = $6,000) = $114,000. Then, subtract Operating Expenses ($45,000) to get NOI: $114,000 - $45,000 = $69,000. Why the other choices are wrong: $71,250 might result from misapplying the 5% vacancy after expenses. $114,000 is the EGI, not NOI. $75,000 incorrectly uses a 5% expense rate. Exam tip: NOI = (PGI - Vacancy) - Operating Expenses. Calculate vacancy loss first.
Why This Is the Correct Answer
Option A ($69,000) correctly follows the NOI calculation formula. First, calculate the vacancy and collection loss: $120,000 × 5% = $6,000. Then subtract this from potential gross income to get effective gross income: $120,000 - $6,000 = $114,000. Finally, subtract operating expenses from effective gross income: $114,000 - $45,000 = $69,000. This systematic approach ensures all income adjustments are properly accounted for before determining the net operating income.
Why the Other Options Are Wrong
Option A: $71,250
Option A ($71,250) appears to result from an incorrect calculation method, possibly applying the vacancy rate incorrectly or making an arithmetic error. This amount doesn't follow the proper NOI calculation sequence and would lead to an inaccurate assessment of the property's income-generating capacity.
Option C: $114,000
Option C ($114,000) represents the effective gross income, not the net operating income. This answer stops the calculation after subtracting vacancy and collection losses ($120,000 - $6,000 = $114,000) but fails to subtract the operating expenses, which is the final and crucial step in determining NOI.
Option D: $75,000
Option D ($75,000) incorrectly subtracts operating expenses directly from potential gross income without first accounting for vacancy and collection losses ($120,000 - $45,000 = $75,000). This skips the critical step of calculating effective gross income and overstates the actual operating performance of the property.
PIG-VEO Formula
PIG - VEO: Potential Income Gross minus Vacancy Equals Operating income (before expenses). Remember: Start with the PIG (Potential Income Gross), remove what's lost to Vacancy, then subtract Expenses to get your Operating income.
How to use: When you see an NOI question, immediately think 'PIG-VEO' and follow the steps: 1) Identify Potential Gross Income, 2) Calculate and subtract Vacancy losses, 3) Subtract Expenses, 4) Result is Operating income (NOI).
Exam Tip
Always perform NOI calculations in the correct sequence and double-check your arithmetic. Write out each step clearly: PGI → subtract vacancy → EGI → subtract operating expenses → NOI.
Common Mistakes to Avoid
- -Forgetting to subtract vacancy and collection losses before calculating NOI
- -Subtracting operating expenses directly from potential gross income
- -Stopping at effective gross income and not completing the NOI calculation
Concept Deep Dive
Analysis
This question tests the fundamental income approach calculation of Net Operating Income (NOI), which is a critical metric in real estate valuation. NOI represents the actual income a property generates after accounting for vacancy losses and operating expenses, but before debt service and capital expenditures. The calculation follows a specific sequence: start with potential gross income, subtract vacancy and collection losses to get effective gross income, then subtract operating expenses to arrive at NOI. This metric is essential for determining property value using capitalization rates and is a key indicator of a property's financial performance.
Background Knowledge
Net Operating Income (NOI) is calculated by starting with potential gross income, subtracting vacancy and collection losses to get effective gross income, then subtracting operating expenses. Operating expenses typically include property taxes, insurance, maintenance, management fees, and utilities, but exclude debt service, depreciation, and capital improvements.
Real-World Application
Appraisers use NOI to determine property values by dividing NOI by a market-derived capitalization rate. Accurate NOI calculation is crucial for investment analysis, loan underwriting, and property valuation in the income approach.
More Income Approach Questions
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