A property generates $48,000 in annual net operating income. Using a capitalization rate of 8%, what is the indicated value using direct capitalization?
Correct Answer
C) $600,000
Why this is correct: The direct capitalization formula is Value = NOI / Cap Rate. Calculation: $48,000 / 0.08 = $600,000. Why the other choices are wrong: '$384,000' results from multiplying NOI by the cap rate ($48,000 * 0.08). '$480,000' uses a 10% cap rate ($48,000 / 0.10). '$640,000' uses a 7.5% cap rate ($48,000 / 0.075). Exam tip: Double-check your math: dividing by 0.08 is the same as multiplying by 12.5. $48,000 * 12.5 = $600,000.
Why This Is the Correct Answer
Option C ($600,000) correctly applies the direct capitalization formula: Value = NOI ÷ Cap Rate. Substituting the given values: $48,000 ÷ 0.08 = $600,000. The calculation converts the decimal capitalization rate (8% = 0.08) properly and performs the division accurately. This result represents the indicated market value based on the property's income-generating capacity and the market-derived capitalization rate.
Why the Other Options Are Wrong
Option A: $384,000
Option A ($384,000) incorrectly multiplies NOI by the cap rate ($48,000 × 0.08 = $3,840, then likely multiplied by 100), which is the reverse of the correct formula and would give an unreasonably low value.
Option B: $480,000
Option B ($480,000) appears to result from using an incorrect cap rate of 10% ($48,000 ÷ 0.10 = $480,000) rather than the given 8% rate, or from some other calculation error.
Option D: $640,000
Option D ($640,000) likely results from incorrectly using a cap rate of 7.5% ($48,000 ÷ 0.075 = $640,000) instead of the given 8%, or from adding an inappropriate factor to the calculation.
NOI Divided by Cap = Value Pride
Remember 'NOI DCV' - NOI Divided by Cap equals Value. Think of it as 'No Darn Complicated Valuations' - the formula is straightforward division, not multiplication.
How to use: When you see a direct capitalization problem, immediately write 'V = NOI ÷ R' at the top of your scratch paper, then plug in the numbers. Always convert percentage cap rates to decimals before calculating.
Exam Tip
Double-check that you're dividing NOI by the cap rate, not multiplying - this is the most common error on direct capitalization questions. Always convert percentages to decimals (8% = 0.08) before calculating.
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
Direct capitalization is a fundamental income approach method that converts a property's stabilized net operating income into an estimate of market value using a single capitalization rate. This method assumes that the income stream is relatively stable and that the capitalization rate accurately reflects market expectations for similar properties. The formula Value = NOI ÷ Cap Rate is derived from the relationship between income, value, and required rates of return that investors expect from real estate investments. Direct capitalization is most appropriate for properties with stable income streams and is widely used for income-producing properties like office buildings, retail centers, and apartment complexes.
Background Knowledge
Direct capitalization is one of two main income approach methods (the other being discounted cash flow analysis) and requires understanding of net operating income calculation and capitalization rate derivation. The capitalization rate represents the relationship between a property's NOI and its value, typically derived from comparable sales of similar income-producing properties.
Real-World Application
Appraisers use direct capitalization daily when valuing rental properties, office buildings, and retail centers. For example, when appraising a small office building, the appraiser would stabilize the rental income, subtract operating expenses to get NOI, then divide by a market-extracted cap rate from recent comparable sales to estimate value.
More Income Approach Questions
A property generates $85,000 in Net Operating Income and sells for $1,062,500. What is the overall capitalization rate?
A property has potential gross income of $180,000, vacancy and collection loss of $15,000, and operating expenses of $65,000. What is the Net Operating Income?
A comparable sale occurred 8 months ago for $425,000. Market conditions indicate property values have increased 0.5% per month since that time. What is the adjusted sale price?
A property generates $150,000 in potential gross income. Market data indicates a 7% vacancy rate and operating expenses of 35% of effective gross income. If the cap rate is 9.5%, what is the indicated value?
A property sold for $320,000 one year ago. If market conditions have improved by 6% since that sale, what is the time-adjusted sale price for comparison purposes?
A commercial building cost $2,500,000 to construct. The land value is $600,000. If the building has suffered 15% physical deterioration and 8% functional obsolescence, what is the depreciated cost of the improvements?
A building's gross rent multiplier (GRM) is 120. If the monthly rent is $2,500, what is the indicated value?
In the cost approach, economic obsolescence is characterized as:
The concept of regression in property values means that:
A commercial property has potential gross income of $120,000, vacancy and collection loss of 8%, and operating expenses of $35,000. Using a cap rate of 9.5%, what is the indicated value?
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
Related Tools
Previous Question
A building has a reproduction cost new of $800,000. Physical deterioration is estimated at $150,000, functional obsolescence at $75,000, and external obsolescence at $50,000. What is the depreciated cost of the building?
Next Question
A comparable sold for $300,000 and carries adjustments of +$12,000, -$5,000, +$3,000 and -$2,000. What is the net adjustment?