A property generates $85,000 in Net Operating Income and has an overall capitalization rate of 8.5%. Using direct capitalization, what is the indicated value?
Correct Answer
B) $1,000,000
Using the formula Value = Income ÷ Rate: $85,000 ÷ 0.085 = $1,000,000. Direct capitalization converts a single year's income into value using an overall capitalization rate.
Why This Is the Correct Answer
Option B ($1,000,000) is correct because it properly applies the direct capitalization formula: Value = Income ÷ Rate. Substituting the given values: $85,000 ÷ 0.085 = $1,000,000. The calculation converts the decimal percentage (8.5% = 0.085) correctly and performs the division accurately. This result represents the market value indication based on the property's income-generating capacity and the market-derived capitalization rate.
Why the Other Options Are Wrong
Option A: $850,000
Option A ($850,000) results from incorrectly multiplying the NOI by the cap rate instead of dividing: $85,000 × 10 = $850,000, which fundamentally misapplies the direct capitalization formula.
Option C: $992,500
Option C ($992,500) appears to result from a calculation error, possibly using an incorrect cap rate or making an arithmetic mistake during the division process.
Option D: $7,225
Option D ($7,225) results from incorrectly multiplying the NOI by the cap rate as a decimal: $85,000 × 0.085 = $7,225, which completely reverses the proper formula application.
VIR - Value Income Rate Triangle
Draw a triangle with V at the top, I and R at the bottom. Cover the unknown variable to see the formula: Cover V = I÷R, Cover I = V×R, Cover R = I÷V. Remember 'Income OVER Rate' for value.
How to use: When you see a direct capitalization problem, immediately draw the VIR triangle, identify what you're solving for (cover that variable), and the remaining variables show your formula operation.
Exam Tip
Always convert percentage cap rates to decimals before calculating (8.5% = 0.085), and remember that value problems typically result in large numbers, so answers under $100,000 are usually calculation errors.
Common Mistakes to Avoid
- -Multiplying NOI by cap rate instead of dividing
- -Forgetting to convert percentage to decimal (using 8.5 instead of 0.085)
- -Confusing overall cap rate with other rates like discount rates or mortgage constants
Concept Deep Dive
Analysis
This question tests the fundamental income approach concept of direct capitalization, which is one of the three primary methods used in real estate appraisal. Direct capitalization converts a single year's stabilized net operating income into an estimate of market value using an overall capitalization rate derived from comparable sales. The formula V = I ÷ R is the cornerstone of income approach valuation and represents the relationship between income, rate, and value. This method assumes that the income stream will continue indefinitely and that the capitalization rate accurately reflects market expectations for similar properties.
Background Knowledge
Direct capitalization is a valuation method that converts annual net operating income into market value using a capitalization rate derived from comparable property sales. The overall capitalization rate represents the relationship between a property's first-year NOI and its sale price, reflecting investor return expectations and market conditions.
Real-World Application
Appraisers use direct capitalization daily when valuing income-producing properties like office buildings, retail centers, and apartment complexes, extracting cap rates from recent comparable sales to convert subject property NOI into market value estimates.
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