A property has a potential gross income of $120,000, vacancy and collection loss of 8%, and operating expenses of $35,000. What is the net operating income (NOI)?
Correct Answer
D) $75,600
Effective Gross Income = $120,000 × (1 - 0.08) = $110,400. NOI = $110,400 - $35,000 = $75,600.
Why This Is the Correct Answer
Option D correctly follows the two-step NOI calculation process. First, the Effective Gross Income is calculated by reducing the Potential Gross Income by the vacancy and collection loss: $120,000 × (1 - 0.08) = $120,000 × 0.92 = $110,400. Then, operating expenses are subtracted from the Effective Gross Income to determine NOI: $110,400 - $35,000 = $75,600. This systematic approach ensures all income adjustments are properly accounted for before determining the property's net operating performance.
Why the Other Options Are Wrong
Option A: $75,400
This answer ($75,400) appears to result from a calculation error, possibly from incorrectly calculating the vacancy loss or making an arithmetic mistake in the final subtraction step.
Option B: $85,000
This answer ($85,000) incorrectly subtracts operating expenses directly from the Potential Gross Income without first accounting for vacancy and collection losses, yielding $120,000 - $35,000 = $85,000.
Option C: $110,400
This answer ($110,400) represents only the Effective Gross Income calculation and fails to subtract the operating expenses, stopping one step short of the complete NOI calculation.
PEG-NOI Formula
Remember 'PEG-NOI': Potential income → Effective income (subtract vacancy) → Gross operating income → Net Operating Income (subtract expenses). Think of a PEG going down step by step.
How to use: When you see an NOI question, visualize the PEG going down: start at the top with Potential Gross Income, step down by removing vacancy losses to get Effective Gross Income, then step down again by removing operating expenses to reach NOI at the bottom.
Exam Tip
Always perform NOI calculations in the correct sequence - never subtract operating expenses directly from Potential Gross Income without first calculating Effective Gross Income by accounting for vacancy and collection losses.
Common Mistakes to Avoid
- -Subtracting operating expenses directly from Potential Gross Income without first calculating Effective Gross Income
- -Forgetting to account for vacancy and collection losses
- -Including debt service or capital expenditures as operating expenses in the NOI calculation
Concept Deep Dive
Analysis
This question tests the fundamental income approach calculation for determining Net Operating Income (NOI), which is a critical metric in real estate valuation. The calculation requires understanding the sequential steps: starting with Potential Gross Income, adjusting for vacancy and collection losses to get Effective Gross Income, then subtracting operating expenses to arrive at NOI. This represents the actual income a property generates after accounting for realistic vacancy rates and all operating costs, but before debt service and capital expenditures. NOI is essential for determining property value using capitalization rates and is a key metric investors use to evaluate property performance.
Background Knowledge
Net Operating Income (NOI) is calculated by starting with Potential Gross Income, subtracting vacancy and collection losses to get Effective Gross Income, then subtracting operating expenses. Operating expenses include items like property taxes, insurance, maintenance, management fees, and utilities, but exclude debt service, depreciation, and capital improvements.
Real-World Application
Appraisers use NOI calculations when applying the income approach to value rental properties, as NOI divided by the capitalization rate yields the property's estimated value. Lenders and investors also rely on NOI to evaluate a property's ability to service debt and generate returns.
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