A property generates $75,000 in net operating income and is valued at $1,000,000. What is the overall capitalization rate?
Correct Answer
B) 7.5%
Why this is correct: The overall capitalization rate (OAR) is calculated as Net Operating Income divided by Value. Formula: OAR = NOI / Value. Calculation: $75,000 / $1,000,000 = 0.075, which is 7.5%. Why the other choices are wrong: 15.0% would be NOI divided by half the value. 13.3% is the inverse (Value/NOI). 0.75% is a misplaced decimal (0.0075). Exam tip: Cap Rate = NOI / Value. This basic formula is fundamental to the income approach.
Why This Is the Correct Answer
Option A (7.5%) is correct because it properly applies the capitalization rate formula. The calculation is straightforward: $75,000 (NOI) ÷ $1,000,000 (value) = 0.075, which converts to 7.5% when expressed as a percentage. This represents the annual return rate that the property's income provides relative to its total value. The 7.5% cap rate indicates that for every dollar invested in this property, the investor can expect to receive 7.5 cents in annual net operating income.
Why the Other Options Are Wrong
Option A: 15.0%
Option A (15.0%) is incorrect and appears to be a distractor with no clear mathematical relationship to the given values. This percentage cannot be derived from any logical manipulation of the $75,000 NOI and $1,000,000 value, suggesting either a calculation error or confusion with other real estate metrics.
Option C: 13.3%
Option C (13.3%) is incorrect because it appears to reverse the formula, calculating value divided by NOI instead of NOI divided by value. This would give approximately $1,000,000 ÷ $75,000 = 13.33, but this calculation has no meaning in cap rate analysis and represents a fundamental misunderstanding of the relationship between income and value.
Option D: 0.75%
Option D (0.75%) is incorrect because it represents the decimal form of the correct answer without converting to percentage form. While 0.075 is the correct decimal calculation, cap rates are always expressed as percentages in real estate practice, making 0.75% an incomplete and misleading representation of the actual cap rate.
NOI Over Value (NOV)
Remember 'NOV' - Net Operating Income goes OVER Value in the fraction. Think 'November' to remember NOI/Value, and that cap rates are like interest rates - always expressed as percentages.
How to use: When you see a cap rate question, immediately think 'NOV' and set up the fraction with NOI on top and Value on bottom. Then convert the decimal result to a percentage by moving the decimal point two places to the right.
Exam Tip
Always double-check that your final cap rate answer is expressed as a percentage and falls within reasonable ranges (typically 3-15% for most commercial properties). If your answer seems unusually high or low, verify your calculation.
Common Mistakes to Avoid
- -Reversing the formula by dividing value by NOI instead of NOI by value
- -Forgetting to convert the decimal result to a percentage
- -Confusing NOI with gross income or other income measures
Concept Deep Dive
Analysis
The overall capitalization rate (cap rate) is a fundamental concept in real estate valuation that measures the relationship between a property's net operating income and its market value. It represents the rate of return an investor can expect from a property based on the income it generates, expressed as a percentage. The cap rate is calculated using the simple formula: Cap Rate = Net Operating Income ÷ Property Value. This metric is essential for comparing investment properties and is widely used in the income approach to valuation. Understanding cap rates helps appraisers and investors assess whether a property is appropriately priced relative to its income-generating potential.
Background Knowledge
The capitalization rate is one of the most important metrics in real estate investment analysis and appraisal practice. It serves as both a valuation tool and a comparative measure, allowing appraisers to assess properties against market standards and helping investors evaluate potential returns. Cap rates vary by property type, location, and market conditions, with lower cap rates typically indicating lower risk or higher property values.
Real-World Application
Appraisers use cap rates daily to value income-producing properties by applying market-derived cap rates to a subject property's NOI. For example, if comparable properties in an area are selling at 7.5% cap rates, an appraiser might value a similar property generating $100,000 NOI at approximately $1,333,333 ($100,000 ÷ 0.075).
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?
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