A property generates annual net operating income of $85,000. Using a capitalization rate of 8.5%, what is the indicated value by direct capitalization?
Correct Answer
C) $1,000,000
Direct capitalization formula: Value = NOI ÷ Cap Rate. $85,000 ÷ 0.085 = $1,000,000.
Why This Is the Correct Answer
Option C is correct because it properly applies the direct capitalization formula: Value = NOI ÷ Cap Rate. Taking the annual NOI of $85,000 and dividing by the capitalization rate of 8.5% (0.085) yields exactly $1,000,000. This calculation shows that an investor paying $1,000,000 for this property would receive an 8.5% return on their investment based on the current NOI. The math is straightforward: $85,000 ÷ 0.085 = $1,000,000.
Why the Other Options Are Wrong
Option A: $850,000
Option A of $850,000 appears to result from incorrectly multiplying NOI by the cap rate ($85,000 × 0.085 = $7,225) or possibly confusing the formula entirely, as $850,000 doesn't mathematically relate to the given figures using proper direct capitalization.
Option B: $950,000
Option B of $950,000 doesn't result from the correct direct capitalization formula and appears to be an arbitrary figure that doesn't mathematically relate to dividing $85,000 by 8.5%.
Option D: $1,058,824
Option D of $1,058,824 appears to result from incorrectly using 8% instead of 8.5% as the cap rate ($85,000 ÷ 0.08 = $1,062,500) or from some other calculation error, as it doesn't equal $85,000 ÷ 0.085.
NOI Divided by Cap = Value Pride
Remember 'NOI DCV' - NOI Divided by Cap equals Value. Think of it as 'No Doubt, Cap Vanishes' - when you divide NOI by the cap rate, the cap rate 'vanishes' and you're left with value.
How to use: When you see NOI and cap rate given together, immediately think 'NOI DCV' and set up the division: NOI ÷ Cap Rate = Value. Never multiply these two figures together.
Exam Tip
Always convert percentage cap rates to decimals before calculating (8.5% = 0.085), and double-check that you're dividing NOI by the cap rate, not multiplying them.
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 in real estate valuation. Direct capitalization converts a single year's net operating income into an indication of value by applying an appropriate capitalization rate. The capitalization rate represents the relationship between income and value, essentially showing what rate of return an investor would expect from the property. This method assumes that the NOI will remain stable or grow at a predictable rate, making it most suitable for stabilized income-producing properties.
Background Knowledge
Direct capitalization is a valuation method within the income approach that converts net operating income into value using a capitalization rate derived from market sales of comparable properties. The capitalization rate reflects the relationship between a property's income and its value, representing the rate of return an investor expects from the investment.
Real-World Application
Appraisers use direct capitalization daily when valuing rental properties, office buildings, and retail centers. They extract cap rates from recent sales of similar properties and apply them to the subject property's stabilized NOI to estimate market value.
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