A property generates $75,000 in net operating income and has an overall capitalization rate of 8.5%. What is the indicated value using direct capitalization?
Correct Answer
B) $882,353
Why this is correct: Direct capitalization formula: Value = NOI ÷ Cap Rate. $75,000 ÷ 0.085 = $882,353. Why the other choices are wrong: '$637,500' results from multiplying NOI by the cap rate ($75,000 × 0.085) instead of dividing. '$750,000' might come from using 10% ($75,000 ÷ 0.10). '$950,000' is not supported by the calculation. Exam tip: Value = NOI / R. Remember: division, not multiplication.
Why This Is the Correct Answer
Option C is correct because it properly applies the direct capitalization formula: Value = NOI ÷ Cap Rate. Substituting the given values: $75,000 ÷ 0.085 = $882,352.94, which rounds to $882,353. This calculation converts the annual net operating income into a present value estimate using the market-derived capitalization rate. The result represents what an investor would theoretically pay for a property generating $75,000 annually at an 8.5% return rate.
Why the Other Options Are Wrong
Option A: $637,500
$637,500 appears to result from incorrectly multiplying NOI by the cap rate ($75,000 × 0.085 = $6,375, then possibly adding zeros incorrectly) rather than dividing, which is a fundamental formula error.
Option C: $750,000
$750,000 would result from dividing NOI by 10% instead of 8.5% ($75,000 ÷ 0.10 = $750,000), indicating the wrong capitalization rate was used in the calculation.
Option D: $950,000
$950,000 is too high and doesn't correspond to any logical mathematical error with the given numbers, suggesting a complete miscalculation or use of wrong input values.
NOI Divided by Cap = Value Pride
Remember 'NOI DCV' - NOI Divided by Cap equals Value. Think 'Detective Catches Villain' where the Detective (NOI) catches the Villain (Value) by dividing through the Cap (barrier).
How to use: When you see NOI and cap rate given, immediately think 'NOI DCV' and set up the division: NOI ÷ Cap Rate = Value. Never multiply these two numbers together.
Exam Tip
Always convert percentage cap rates to decimals before calculating (8.5% = 0.085), and double-check that you're dividing NOI by the cap rate, not multiplying - this is the most common error on cap rate questions.
Common Mistakes to Avoid
- -Multiplying NOI by cap rate instead of dividing
- -Forgetting to convert percentage to decimal form
- -Using gross income instead of net operating income
Concept Deep Dive
Analysis
This question tests the fundamental direct capitalization formula, which is the cornerstone of the income approach to real estate valuation. Direct capitalization converts a single year's net operating income into an estimate of value by dividing NOI by an appropriate capitalization rate. The capitalization rate reflects the relationship between income and value for similar properties in the market. This method assumes that the property's income and expenses are stabilized and representative of future performance. Understanding this formula is essential because it's one of the most frequently used valuation methods for income-producing properties.
Background Knowledge
The income approach estimates value based on a property's ability to generate income, with direct capitalization being the most straightforward method. Net Operating Income (NOI) represents the property's annual income after operating expenses but before debt service and taxes, while the capitalization rate reflects market expectations for return on investment for similar properties.
Real-World Application
Appraisers use direct capitalization daily when valuing rental properties, office buildings, and retail centers. They extract cap rates from comparable sales, then apply this rate to the subject property's stabilized NOI to estimate market value for lending, taxation, or investment decisions.
More Income Approach Questions
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