A property generates $85,000 in Net Operating Income and sells for $1,062,500. What is the overall capitalization rate?
Correct Answer
A) 8.0%
Why this is correct: The overall capitalization rate (R) is a fundamental metric in the income approach, defined as the ratio of a property's Net Operating Income (NOI) to its sale price or value. The calculation is a direct application of the formula: R = NOI / Value. Here, NOI is $85,000 and the sale price is $1,062,500. Performing the division: $85,000 ÷ $1,062,500 = 0.08, which converts to 8.0%. Why the other choices are wrong: "6.8%" results from incorrectly dividing the sale price by the NOI ($1,062,500 ÷ $85,000 ≈ 12.5) and then perhaps misinterpreting the inverse. "7.5%" is a plausible but incorrect rate not supported by the given numbers. "12.5%" is the inverse of the correct calculation (Value/NOI), representing a gross income multiplier, not a cap rate. Exam tip: Remember the cap rate formula: Cap Rate = NOI / Value. It's a percentage, so move the decimal two places. On the exam, double-check that you are dividing NOI by value, not the other way around.
Why This Is the Correct Answer
Option A (8.0%) is correct because it follows the standard cap rate formula: NOI ÷ Sale Price. Using the given figures: $85,000 ÷ $1,062,500 = 0.08 = 8.0%. This calculation is straightforward division that converts to a percentage by moving the decimal point two places to the right. The 8.0% cap rate indicates that the property generates an 8% annual return based on its purchase price, which is a reasonable cap rate for many commercial real estate markets.
Why the Other Options Are Wrong
Option B: 6.8%
Option B (6.8%) is incorrect and likely results from a calculation error, possibly from rounding errors or using incorrect figures in the formula. There's no logical mathematical path from the given NOI and sale price that would yield 6.8%.
Option C: 7.5%
Option C (7.5%) is incorrect and appears to be another calculation error. This percentage doesn't result from the proper application of the cap rate formula using the given NOI of $85,000 and sale price of $1,062,500.
Option D: 12.5%
Option D (12.5%) is incorrect because it appears to be the result of incorrectly dividing the sale price by the NOI ($1,062,500 ÷ $85,000 = 12.5), which is the inverse of the correct cap rate formula. This would give you a price-to-income ratio rather than a capitalization rate.
NOI Over Price = Cap Rate Slice
Remember 'NOP' - NOI Over Price = Cap Rate. Think of it as slicing the NOI pie by the price to get your cap rate slice. The bigger the price, the smaller your slice (lower cap rate).
How to use: When you see a cap rate question, immediately think 'NOP' and set up the fraction with NOI on top and Price on the bottom. Convert the decimal result to a percentage.
Exam Tip
Always double-check that you're dividing NOI by price, not price by NOI. The cap rate should typically fall between 4-12% for most commercial properties, so if your answer is outside this range, recalculate.
Common Mistakes to Avoid
- -Dividing sale price by NOI instead of NOI by sale price
- -Forgetting to convert the decimal result to a percentage
- -Using gross income instead of net operating income in the calculation
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 or sale price. It represents the rate of return an investor can expect from a property based on the income it generates, assuming the property was purchased with cash. The cap rate is expressed as a percentage and is calculated by dividing the annual Net Operating Income (NOI) by the property's sale price or current market value. This metric is crucial for comparing investment properties and understanding market conditions, as higher cap rates generally indicate higher risk or lower property values, while lower cap rates suggest lower risk or higher property values.
Background Knowledge
The capitalization rate is one of the three primary methods used in the income approach to real estate valuation, alongside gross rent multipliers and discounted cash flow analysis. Understanding cap rates is essential for appraisers because they reflect market conditions, risk levels, and investor expectations for different property types and locations.
Real-World Application
Appraisers use cap rates to value income-producing properties by analyzing recent sales of comparable properties. If similar properties in an area are selling at 8% cap rates, an appraiser can estimate the value of a subject property by dividing its NOI by 0.08.
More Income Approach Questions
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?
A property sold 18 months ago for $500,000. Current market conditions indicate property values have increased 1.5% per year. The property is inferior to the subject by $25,000 in location. What is the adjusted sale price?
People Also Study
Real Estate Market
13.6% of exam
Property Description
11.8% of exam
Land or Site Valuation
4.5% of exam
Sales Comparison Approach
16.4% of exam
Cost Approach
13.6% of exam