A property has a potential gross income of $120,000, vacancy and collection loss of 8%, and operating expenses of $45,000. What is the Net Operating Income?
Correct Answer
A) $65,400
NOI calculation: Potential Gross Income ($120,000) less vacancy/collection loss ($120,000 × 8% = $9,600) equals Effective Gross Income ($110,400), then less operating expenses ($45,000) equals NOI of $65,400.
Why This Is the Correct Answer
Option A ($65,400) correctly follows the NOI calculation sequence. First, calculate the vacancy loss: $120,000 × 8% = $9,600. Then find Effective Gross Income: $120,000 - $9,600 = $110,400. Finally, subtract operating expenses from EGI: $110,400 - $45,000 = $65,400. This represents the true net operating income available to the property owner before debt service and income taxes.
Why the Other Options Are Wrong
Option B: $75,000
Option B ($75,000) incorrectly calculates NOI by subtracting only the operating expenses from potential gross income ($120,000 - $45,000 = $75,000), completely ignoring the vacancy and collection loss adjustment. This overstates the actual income the property will generate.
Option C: $110,400
Option C ($110,400) represents the Effective Gross Income, not the Net Operating Income. This answer stops the calculation after subtracting vacancy losses but fails to deduct the operating expenses of $45,000.
Option D: $120,000
Option D ($120,000) is simply the Potential Gross Income with no adjustments made. This ignores both the vacancy/collection losses and operating expenses, representing an unrealistic income figure that assumes 100% occupancy and no operating costs.
PEG-NO Formula
Remember 'PEG-NO': Potential income, subtract Empty spaces (vacancy), equals Gross effective income, subtract eNding Operational costs, equals Net Operating income. Think of a PEG (clothespin) holding money, but some falls out (vacancy) and more gets spent (operations).
How to use: When you see an NOI question, immediately think 'PEG-NO' and follow the sequence: identify Potential income, calculate Empty space losses, find Gross effective income, subtract eNding Operational costs to get Net Operating income.
Exam Tip
Always work through NOI calculations step-by-step and write down each intermediate result (vacancy loss amount, effective gross income) to avoid calculation errors and ensure you don't skip steps.
Common Mistakes to Avoid
- -Forgetting to subtract vacancy and collection losses from potential gross income
- -Subtracting operating expenses from potential gross income instead of effective gross income
- -Including debt service or depreciation as operating expenses in the NOI calculation
Concept Deep Dive
Analysis
This question tests the fundamental income approach calculation for Net Operating Income (NOI), which is a critical metric in real estate valuation. NOI represents the actual income a property generates after accounting for realistic vacancy rates and all operating expenses, but before debt service and taxes. The calculation follows a specific sequence: start with Potential Gross Income, subtract vacancy and collection losses to get Effective Gross Income, then subtract operating expenses to arrive at NOI. This metric is essential for determining property value using capitalization rates and for comparing investment properties.
Background Knowledge
Net Operating Income is calculated using the formula: NOI = Effective Gross Income - Operating Expenses, where Effective Gross Income = Potential Gross Income - Vacancy & Collection Losses. Operating expenses include items like maintenance, utilities, insurance, property taxes, and management fees, but exclude debt service, depreciation, and income taxes.
Real-World Application
Appraisers use NOI calculations when valuing income-producing properties like apartment buildings, office complexes, or retail centers. The NOI figure is then divided by a market-derived capitalization rate to estimate the property's value, making accurate NOI calculation crucial for reliable valuations.
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