A property generates annual NOI of $75,000. Using a capitalization rate of 8.5%, what is the indicated value by direct capitalization?
Correct Answer
C) $882,353
Value = NOI ÷ Capitalization Rate. $75,000 ÷ 0.085 = $882,353. This is the basic direct capitalization formula used in the income approach.
Why This Is the Correct Answer
Option C is correct because it properly applies the direct capitalization formula: Value = NOI ÷ Cap Rate. Taking $75,000 ÷ 0.085 = $882,352.94, which rounds to $882,353. This calculation converts the annual income stream into a present value indication by using the market-derived capitalization rate. The formula essentially asks: 'What amount of money, when multiplied by 8.5%, would produce $75,000 in annual income?'
Why the Other Options Are Wrong
Option A: $637,500
This appears to be the result of multiplying NOI by the cap rate ($75,000 × 0.085 = $6,375) then multiplying by 100, which is an incorrect application of the formula.
Option B: $750,000
This equals the NOI amount itself ($75,000), suggesting the candidate forgot to perform any calculation or confused NOI with the final value indication.
Option D: $6,375
This is the result of incorrectly multiplying NOI by the cap rate ($75,000 × 0.085 = $6,375) instead of dividing, which reverses the proper mathematical relationship.
NOI Divided by Cap = Value Pride
Remember 'NOI ÷ CAP = VALUE' with the phrase 'Never Over-complicate Income ÷ Cap Always Produces VALUE.' Also use 'Big ÷ Small = Bigger' - NOI (bigger number) divided by cap rate (small decimal) equals value (bigger number).
How to use: When you see NOI and cap rate together, immediately think 'divide NOI by cap rate.' If your answer is smaller than the NOI, you multiplied instead of divided and need to recalculate.
Exam Tip
Always convert percentage cap rates to decimals (8.5% = 0.085) before calculating, and double-check that your final value is larger than the NOI - if it's smaller, you likely multiplied instead of divided.
Common Mistakes to Avoid
- -Multiplying NOI by cap rate instead of dividing
- -Forgetting to convert percentage to decimal (using 8.5 instead of 0.085)
- -Using gross income instead of net operating income in the calculation
Concept Deep Dive
Analysis
This question tests the fundamental direct capitalization formula used in the income approach to real estate valuation. Direct capitalization is a method where the appraiser converts a single year's income into an indication of value by dividing the Net Operating Income (NOI) by an appropriate capitalization rate. The capitalization rate represents the relationship between income and value for similar properties in the market. This method assumes that the property will continue to generate stable income and that the cap rate accurately reflects market expectations for risk and return.
Background Knowledge
The income approach is one of three primary valuation approaches in real estate appraisal, alongside the sales comparison and cost approaches. Direct capitalization specifically converts one year's stabilized NOI into value using a cap rate derived from comparable sales or market surveys.
Real-World Application
Appraisers use direct capitalization daily when valuing income-producing properties like office buildings, retail centers, and apartment complexes. They extract cap rates from recent comparable sales and apply them to the subject property's stabilized NOI to estimate market value for lending, taxation, or sale purposes.
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