The subject property is a triplex. The owner's report shows income of $42,600 for the year just ended: cash receipts of $66,000 less operating expenses of $23,400, including property taxes. The receipts include $2,700 of refundable security deposits collected from new tenants and $1,500 of next January's rent paid early in December. No deposits were refunded during the year, and all of the year's rent was collected in that year. The other figures are typical of the market. The market overall rate is 7.5%, and the owner's mortgage carries an 8.4% interest rate. By how much would capitalizing the reported income overstate the indicated value?
Correct Answer
D) $56,000
A refundable deposit is money held for the tenant, and next January's rent belongs to next year's income, so $4,200 of the receipts is not this year's income. At the 7.5% market rate, $4,200 ÷ 0.075 = $56,000 of overstatement. Removing only the deposits gives $36,000 and removing only the prepaid rent gives $20,000. Using the mortgage's 8.4% interest rate gives $50,000.
Why This Is the Correct Answer
Option D is correct because neither the $2,700 of refundable deposits nor the $1,500 of next January's rent is this year's income. Together they overstate income by $4,200. At the 7.5% market rate, that is $4,200 ÷ 0.075 = $56,000, the difference between $568,000 and $512,000.
Why the Other Options Are Wrong
Option A: $20,000
Option A shows $20,000, which is $1,500 ÷ 0.075. It removes the prepaid rent but leaves the $2,700 of refundable deposits in income; removing both gives $4,200 ÷ 0.075 = $56,000.
Option B: $36,000
Option B shows $36,000, which is $2,700 ÷ 0.075. It removes the deposits but counts next January's $1,500 as this year's income; removing both gives $4,200 ÷ 0.075 = $56,000.
Option C: $50,000
Option C shows $50,000, which is $4,200 ÷ 0.084. The 8.4% is the interest rate on the owner's mortgage, not a rate for capitalizing property income; at the 7.5% overall rate, the overstatement is $56,000.
Earned, kept, this year
Count a receipt only if the property earned it, the owner keeps it, and it belongs to this year.
How to use: Use this test on each line of an owner's receipts before building effective gross income.
Exam Tip
Small items can matter because capitalization magnifies them: at 7.5%, each dollar of income has the value effect of about $13.33. Use the market overall rate, and set aside the mortgage interest rate.
Common Mistakes to Avoid
- -Counting refundable security deposits as income
- -Counting rent paid in advance for next year in this year's income
- -Capitalizing income at a mortgage interest rate instead of the overall rate
Concept Deep Dive
Analysis
This tests whether a candidate reads what is inside a receipts figure instead of accepting it as income. Security deposits are refundable, and rent prepaid for next January is income of a different year. Once both are removed, the overstated income is capitalized at the market overall rate to measure the effect on value.
Background Knowledge
Direct capitalization converts one year's income into value, so the income figure has to represent one year of what the property earns. A cash receipt is not necessarily income of that year. Refundable deposits are held for tenants, and prepaid rent relates to a later period.
Real-World Application
A small landlord gives an appraiser a bank-deposit summary as the income statement. The appraiser compares it with the rent roll and finds deposits from new tenants and rent paid ahead for the next month. The appraiser removes them before estimating income for the valuation.
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