A property generates $85,000 in Net Operating Income and is valued using a 9.5% capitalization rate. What is the indicated value by direct capitalization?
Correct Answer
D) $894,737
Why this is correct: Direct capitalization estimates value by dividing the Net Operating Income (NOI) by the capitalization rate (R). Formula: Value = NOI / R. Calculation: 85,000 / 0.095 = 894,736.84, which rounds to $894,737. Why the other choices are wrong: "$8,075" results from multiplying NOI by the cap rate. "$93,075" results from adding NOI and cap rate percentage. "$850,000" uses a 10% cap rate (85,000/0.10). Exam tip: The cap rate formula V = I/R is fundamental. Remember, a higher cap rate means a lower value, all else equal.
Why This Is the Correct Answer
Option A is correct because it properly applies the direct capitalization formula: Value = NOI ÷ Cap Rate. Converting the percentage to decimal form: 9.5% = 0.095, then dividing $85,000 ÷ 0.095 = $894,736.84, which rounds to $894,737. This calculation follows the standard income approach methodology where NOI is divided by the capitalization rate to determine market value.
Why the Other Options Are Wrong
NOI Divided by Cap = Value Pride
Remember 'NOI ÷ CAP = VALUE' with the phrase 'Never Over-complicate Income ÷ Cap Always Produces VALUE' or use the visual: NOI sits on top of Cap Rate like a fraction, with Value as the result.
How to use: When you see NOI and cap rate in a problem, immediately visualize the fraction NOI/Cap Rate and remember that income divided by rate equals value, never multiply these two figures together.
Exam Tip
Always convert percentage cap rates to decimals before calculating (9.5% becomes 0.095), and double-check that you're dividing NOI by the cap rate, not multiplying - the value should be larger than the NOI.
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 income approach concept of direct capitalization, which is one of the three primary methods used to value income-producing real estate. Direct capitalization converts a single year's Net Operating Income (NOI) into an estimate of market value by applying an appropriate capitalization rate. The capitalization rate represents the relationship between NOI and value, reflecting the rate of return an investor would expect from the property. This method assumes that the NOI is stabilized and representative of the property's ongoing income potential.
Background Knowledge
Direct capitalization is a valuation method within the income approach that converts NOI into market value using a single capitalization rate. The cap rate is derived from comparable sales of similar income properties and represents the overall rate of return expected by investors in that market.
Real-World Application
Appraisers use direct capitalization daily when valuing apartment buildings, office buildings, and retail properties by analyzing the subject's NOI and applying cap rates derived from recent sales of comparable income properties in the same market.
More Income Approach Questions
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