A property generates annual NOI of $75,000. If the capitalization rate is 7.5%, what is the indicated value?
Correct Answer
A) $1,000,000
Why this is correct: The direct capitalization formula is Value = Net Operating Income (NOI) ÷ Capitalization Rate (R). Here, $75,000 ÷ 0.075 = $1,000,000. Why the other choices are wrong: "$800,000" results from using 9.375% ($75,000/$800,000). "$900,000" uses an 8.33% cap rate. "$562,500" mistakenly multiplies NOI by the cap rate ($75,000 × 0.075). Exam tip: In direct capitalization, Value = NOI / R. Remember: division, not multiplication. Check your math: $1,000,000 × 7.5% = $75,000.
Why This Is the Correct Answer
Option B is correct because it properly applies the income capitalization formula: Value = NOI ÷ Capitalization Rate. Substituting the given values: $75,000 ÷ 0.075 = $1,000,000. The calculation requires converting the percentage cap rate (7.5%) to its decimal equivalent (0.075) before performing the division. This straightforward application of the formula yields the indicated market value of the income-producing property.
Why the Other Options Are Wrong
Option B: $800,000
This answer of $800,000 suggests an error in decimal conversion or arithmetic, possibly using 0.09375 as the divisor instead of the correct 0.075.
Option C: $900,000
This answer of $900,000 suggests an error in the cap rate conversion or calculation, possibly using an incorrect divisor of approximately 0.083 instead of 0.075.
Option D: $562,500
This answer of $562,500 indicates the student multiplied NOI by the cap rate ($75,000 × 0.075) instead of dividing, which is the opposite operation and a fundamental conceptual error.
NOI Divided by Cap = Value Pride
Remember 'NOI over Cap gives you the MAP' - NOI over (divided by) Cap rate gives you the Market value And Price. Visualize NOI sitting on top of Cap rate in a fraction, with the result being the property's value.
How to use: When you see NOI and cap rate given, immediately set up the fraction NOI/Cap Rate. Always convert percentage cap rates to decimals (move decimal point two places left). The result will always be larger than the NOI since you're dividing by a number less than 1.
Exam Tip
Always double-check that you're dividing NOI by cap rate, not multiplying - the value should be significantly larger than the annual NOI for typical cap rates between 4-12%.
Common Mistakes to Avoid
- -Multiplying NOI by cap rate instead of dividing
- -Forgetting to convert percentage cap rate to decimal form
- -Using gross income instead of net operating income
Concept Deep Dive
Analysis
This question tests the fundamental income capitalization approach formula, which is one of the three primary valuation methods in real estate appraisal. The capitalization rate method converts a single year's net operating income into an estimate of market value by applying a market-derived capitalization rate. This approach assumes that the NOI represents a stabilized, typical year of income and that the cap rate accurately reflects market expectations for similar properties. The formula Value = NOI ÷ Cap Rate is the cornerstone of income property valuation and must be memorized and applied correctly.
Background Knowledge
The income capitalization approach is based on the principle that value equals the present worth of future income benefits. The capitalization rate represents the relationship between net operating income and market value, derived from comparable sales of similar income properties. Net Operating Income is calculated as gross income minus vacancy and operating expenses, but excludes debt service and depreciation.
Real-World Application
Appraisers use this method daily when valuing apartment buildings, office buildings, retail centers, and other income properties. They gather market cap rates from recent sales of comparable properties and apply them to the subject property's stabilized NOI to estimate market value.
More Income Approach Questions
A building cost $2,500,000 to construct 8 years ago. Using straight-line depreciation over a 40-year life, what is the current depreciated value?
The following sale prices were recorded: $245,000, $250,000, $250,000, $255,000, $280,000. What is the mode?
A property has a replacement cost of $1,800,000. Physical deterioration is estimated at $200,000, functional obsolescence at $150,000, and external obsolescence at $100,000. What is the depreciated value using the breakdown method?
What is the present value of $150,000 to be received in 5 years, assuming a discount rate of 8%?
A triangular lot has a base of 100 feet and a height of 80 feet. What is the area in square feet?
An irregular lot can be divided into a rectangle (100' × 80') and a triangle (base 60', height 40'). What is the total area in acres?
A property has a net operating income of $85,000 and annual debt service of $68,000. What is the debt coverage ratio?
A warehouse has interior dimensions of 120 feet × 80 feet × 20 feet high. What is the volume in cubic feet?
A property is purchased for $500,000 with a loan of $400,000. What is the loan-to-value ratio?
A property sold for $400,000 with annual gross rent of $40,000. What is the gross rent multiplier?
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
Related Tools
Previous Question
A property has equity of $200,000 and generates annual cash flow before taxes of $18,000. What is the equity dividend rate?
Next Question
A building cost $2,500,000 to construct. After 8 years, it has accrued depreciation of $400,000. Using straight-line depreciation, what is the annual depreciation amount?