A property generates annual NOI of $75,000 and sold for $1,000,000. What is the overall capitalization rate?
Correct Answer
A) 7.5%
Why this is correct: The overall capitalization rate (R) is calculated as Net Operating Income (NOI) divided by Sale Price (Value). R = $75,000 / $1,000,000 = 0.075 or 7.5%. Why the other choices are wrong: "13.3%" incorrectly divides price by income ($1,000,000 / $75,000). "7.0%" and "8.0%" are close but result from misapplying the formula or using incorrect numbers. Exam tip: Cap Rate = NOI / Value. Keep the order straight: Income over Value.
Why This Is the Correct Answer
Option A (7.5%) is correct because it follows the standard cap rate formula: NOI ÷ Sale Price. Using the given values: $75,000 ÷ $1,000,000 = 0.075 = 7.5%. This calculation is straightforward division that converts to a percentage by moving the decimal point two places to the right. The 7.5% cap rate indicates that the property generates a 7.5% annual return based on its purchase price, which is a reasonable cap rate for many commercial properties in stable markets.
Why the Other Options Are Wrong
Option B: 13.3%
Option B (13.3%) is incorrect because it appears to be the result of dividing the sale price by the NOI instead of NOI by sale price ($1,000,000 ÷ $75,000 = 13.33). This reverses the cap rate formula and would represent a gross income multiplier concept rather than a capitalization rate. This is a common error when students confuse the numerator and denominator in the cap rate calculation.
Option C: 7.0%
Option C (7.0%) is incorrect because it doesn't match the mathematical result of the cap rate calculation. While 7.0% might seem close to the correct answer, precision is crucial in appraisal calculations. This could result from rounding errors or miscalculation during the division process.
Option D: 8.0%
Option D (8.0%) is incorrect as it doesn't correspond to the actual calculation result. This answer might come from estimation or rounding $75,000 to $80,000 before performing the calculation, which would yield 8.0%. However, appraisers must use precise figures as given in the problem.
NOI Over Sale = Cap Rate Tale
Remember 'NOS' - NOI Over Sale. Think of it as 'NOS' (like the car racing fuel) gives you the 'rate' of speed. NOI goes on top (numerator), Sale price goes on bottom (denominator), and you get your cap rate percentage.
How to use: When you see a cap rate question, immediately think 'NOS' and set up the fraction: NOI (top) ÷ Sale Price (bottom). Convert the decimal result to a percentage by multiplying by 100 or moving the decimal two places right.
Exam Tip
Always double-check that you're dividing NOI by sale price, not the reverse. Write out the formula before calculating to avoid confusion, and remember to express your final answer as a percentage.
Common Mistakes to Avoid
- -Reversing the formula by dividing sale price by NOI
- -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 metric 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, expressed as a percentage. The cap rate is calculated by dividing the annual NOI by the property's sale price or market value. This metric is essential for comparing investment properties and determining market-derived capitalization rates for the income approach to valuation. Cap rates vary by property type, location, market conditions, and risk factors.
Background Knowledge
The overall capitalization rate is derived from market sales data and represents the relationship between income and value for comparable properties. It's used in the direct capitalization method of the income approach, where Value = NOI ÷ Cap Rate. Understanding cap rates is essential for income-producing property valuation and investment analysis.
Real-World Application
Appraisers use market-derived cap rates from recent comparable sales to value subject properties using the income approach. For example, if several similar office buildings sold with cap rates around 7.5%, an appraiser might apply this rate to a subject property's NOI to estimate its market value.
More Income Approach Questions
A property generates $85,000 in Net Operating Income and sells for $1,062,500. What is the overall capitalization rate?
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?
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