A property has a gross annual income of $120,000 and operating expenses of $45,000. If the capitalization rate is 8%, what is the indicated value using direct capitalization?
Correct Answer
A) $937,500
Net Operating Income = $120,000 - $45,000 = $75,000. Value = NOI ÷ Cap Rate = $75,000 ÷ 0.08 = $937,500.
Why This Is the Correct Answer
Option A is correct because it follows the proper direct capitalization formula sequence. First, calculate NOI: $120,000 gross income minus $45,000 operating expenses equals $75,000 NOI. Then apply the direct capitalization formula: Value = NOI ÷ Cap Rate = $75,000 ÷ 0.08 = $937,500. This methodology properly converts the property's income stream into a market value indication using the given capitalization rate.
Why the Other Options Are Wrong
Option B: $1,500,000
$1,500,000 results from incorrectly using gross income instead of NOI in the calculation ($120,000 ÷ 0.08), which violates the fundamental principle that capitalization rates must be applied to net operating income, not gross income.
Option C: $562,500
$562,500 appears to result from using operating expenses instead of NOI ($45,000 ÷ 0.08), which makes no economic sense as property value should be based on income generation capacity, not expenses.
Option D: $1,875,000
$1,875,000 seems to come from adding gross income and expenses then dividing by cap rate (($120,000 + $45,000) ÷ 0.08), which is mathematically and conceptually incorrect for income capitalization.
NOI-CAP Memory Formula
Remember 'VINO-CAP': Value = Income (NOI) ÷ CAP rate. Think of pouring wine (VINO) - you need the right CAP (capitalization rate) to contain the income flow and determine value.
How to use: When you see direct capitalization problems, immediately think 'VINO-CAP' and follow these steps: 1) Calculate NOI (Gross Income - Operating Expenses), 2) Identify the cap rate, 3) Divide NOI by cap rate for value.
Exam Tip
Always calculate NOI first before applying any capitalization rate - never use gross income directly in the cap rate formula, and double-check that you're subtracting expenses, not adding them.
Common Mistakes to Avoid
- -Using gross income instead of NOI in the capitalization formula
- -Adding expenses to income instead of subtracting them
- -Forgetting to convert percentage cap rates to decimal form (8% = 0.08)
Concept Deep Dive
Analysis
This question tests the fundamental income approach concept of direct capitalization, which is one of the three primary methods for determining property value in real estate appraisal. Direct capitalization converts a single year's net operating income into an indication of value by dividing NOI by an appropriate capitalization rate. The process requires calculating Net Operating Income (NOI) by subtracting operating expenses from gross income, then applying the capitalization rate formula. This method assumes the property will generate stable income and that the cap rate accurately reflects market conditions and risk.
Background Knowledge
Direct capitalization is an income approach method that converts net operating income into property value using a capitalization rate derived from comparable sales. The cap rate reflects the relationship between a property's NOI and its market value, incorporating factors like risk, growth expectations, and market conditions.
Real-World Application
Appraisers use direct capitalization daily when valuing income-producing properties like apartment buildings, office complexes, and retail centers, where they analyze actual operating statements and apply market-derived cap rates to estimate current market value for lending, taxation, or sale purposes.
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