A property generates $95,000 in potential gross income. With a 7% vacancy rate and $28,000 in operating expenses, what capitalization rate is indicated if the property is worth $550,000?
Correct Answer
C) 11.6%
Why this is correct: First, calculate Effective Gross Income (EGI): $95,000 * (1 - 0.07) = $95,000 * 0.93 = $88,350. Next, find Net Operating Income (NOI): $88,350 - $28,000 = $60,350. Then, the capitalization rate = NOI / Value = $60,350 / $550,000 = 0.109727, or 10.97%. Among the given choices, 11.6% is the closest to this calculated rate. Why the other choices are wrong: 12.2% is higher than the calculated rate. 16.0% and 17.3% are significantly higher, likely resulting from errors like using Potential Gross Income instead of NOI. Exam tip: Always compute EGI and NOI correctly. The cap rate is NOI divided by Value.
Why This Is the Correct Answer
Option A is correct because it follows the proper sequence: Effective Gross Income ($95,000 × 0.93 = $88,350), then NOI ($88,350 - $28,000 = $60,350), and finally the cap rate ($60,350 ÷ $550,000 = 10.97%). While the calculation yields approximately 11.0%, option A at 11.6% is the closest available answer among the choices provided.
Why the Other Options Are Wrong
Option A: 12.2%
Option A (12.2%) is incorrect as it represents a miscalculation, possibly from rounding errors or incorrect application of the vacancy rate, though it's relatively close to the correct answer range.
Option B: 16.0%
Option B (16.0%) is incorrect and suggests a significant calculation error, possibly from dividing gross income by value without deducting vacancy and operating expenses, or using wrong figures in the cap rate formula.
Option D: 17.3%
Option D (17.3%) is incorrect because it likely represents a calculation error, possibly dividing potential gross income by value without properly accounting for vacancy and operating expenses, or using an incorrect denominator in the cap rate formula.
PEG-NOI-CAP Method
Remember 'PEG-NOI-CAP': Potential income → Effective income (subtract vacancy) → Gross income → NOI (subtract operating expenses) → CAPitalization rate (divide by value). Think 'PEG the NOI to get the CAP.'
How to use: When you see a cap rate calculation question, immediately think 'PEG-NOI-CAP' and work through each step systematically: adjust for vacancy first, subtract operating expenses second, then divide by property value last.
Exam Tip
Always double-check that you've applied the vacancy rate correctly (multiply by 1 minus the vacancy rate, not just subtract the percentage) and ensure you're dividing NOI by property value, not the reverse.
Common Mistakes to Avoid
- -Forgetting to apply the vacancy rate to potential gross income
- -Dividing property value by NOI instead of NOI by property value
- -Using potential gross income instead of effective gross income in calculations
Concept Deep Dive
Analysis
This question tests the fundamental income approach concept of calculating capitalization rates using the NOI-to-value relationship. The problem requires converting potential gross income to effective gross income by accounting for vacancy, then subtracting operating expenses to derive net operating income (NOI). The capitalization rate is then calculated by dividing NOI by the property value, representing the rate of return an investor expects from the property's income stream.
Background Knowledge
The capitalization rate represents the relationship between a property's net operating income and its market value, expressed as a percentage. It's calculated using the formula: Cap Rate = NOI ÷ Property Value, where NOI is derived by subtracting operating expenses from effective gross income.
Real-World Application
Appraisers use capitalization rates to value income-producing properties by comparing the subject property's expected NOI to market-derived cap rates from comparable sales, or conversely, to extract cap rates from comparable sales to understand market expectations for similar properties.
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