A property generates effective gross income of $150,000 and has operating expenses of $45,000. If the overall capitalization rate is 9%, what is the indicated value?
Correct Answer
A) $1,166,667
Net Operating Income = $150,000 - $45,000 = $105,000. Value = NOI ÷ Cap Rate = $105,000 ÷ 0.09 = $1,166,667.
Why This Is the Correct Answer
Option A is correct because it follows the proper two-step income approach calculation. First, NOI is calculated by subtracting operating expenses ($45,000) from effective gross income ($150,000), yielding $105,000. Second, the value is determined by dividing NOI ($105,000) by the capitalization rate (9% or 0.09), resulting in $1,166,667. This represents the present value of the property's income stream.
Why the Other Options Are Wrong
Option B: $1,500,000
This answer ($1,500,000) incorrectly uses the effective gross income ($150,000) divided by the cap rate (0.09) without first subtracting operating expenses to calculate NOI. This fundamental error ignores the fact that operating expenses must be deducted before applying the capitalization rate.
Option C: $1,666,667
This answer ($1,666,667) appears to divide the effective gross income ($150,000) by 0.09, but the calculation is mathematically incorrect even for that wrong approach. It also fails to properly calculate NOI by subtracting operating expenses first.
Option D: $2,166,667
This answer ($2,166,667) significantly overvalues the property and doesn't correspond to any logical calculation using the given figures. It appears to be a distractor that might result from multiple calculation errors or misunderstanding the basic income approach formula.
NOI-CAP Memory Method
Remember 'NOI before you CAP it!' - Always calculate Net Operating Income first (Effective Gross Income minus Operating Expenses), then divide by the CAPitalization rate. Think: 'No Operating Income, No CAPital value!'
How to use: When you see an income approach question, immediately identify the three components: 1) Effective Gross Income, 2) Operating Expenses, 3) Cap Rate. Always subtract #2 from #1 to get NOI, then divide NOI by #3.
Exam Tip
Double-check that you're using NOI (after subtracting expenses) and not effective gross income in your cap rate calculation. Many wrong answers are designed to catch this common error.
Common Mistakes to Avoid
- -Using effective gross income instead of NOI in the capitalization formula
- -Forgetting to convert the percentage cap rate to decimal form (9% = 0.09)
- -Adding instead of subtracting operating expenses from effective gross income
Concept Deep Dive
Analysis
This question tests the fundamental income approach formula used in real estate valuation, specifically the direct capitalization method. The income approach is one of the three primary valuation methods and requires calculating Net Operating Income (NOI) by subtracting operating expenses from effective gross income. The capitalization rate is then used to convert the income stream into a present value estimate. This method assumes the property will generate consistent income and that the cap rate accurately reflects market conditions and risk.
Background Knowledge
The income approach to valuation uses the formula: Value = Net Operating Income ÷ Capitalization Rate. Net Operating Income (NOI) is calculated by subtracting operating expenses from effective gross income, representing the actual cash flow available to the property owner before debt service and taxes.
Real-World Application
Appraisers use this method daily when valuing income-producing properties like apartment buildings, office complexes, and retail centers. The cap rate reflects current market conditions and investor expectations, while NOI represents the property's actual earning potential after all operating costs.
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