A property has a potential gross income of $120,000, vacancy and collection loss of 5%, and operating expenses of $45,000. What is the Net Operating Income (NOI)?
Correct Answer
A) $69,000
Effective Gross Income = $120,000 × (1 - 0.05) = $114,000. Net Operating Income = $114,000 - $45,000 = $69,000. NOI is calculated by subtracting operating expenses from effective gross income.
Why This Is the Correct Answer
Option A ($69,000) correctly follows the proper NOI calculation sequence. First, the Potential Gross Income of $120,000 is reduced by the 5% vacancy and collection loss: $120,000 × 0.95 = $114,000 Effective Gross Income. Then, operating expenses of $45,000 are subtracted from the Effective Gross Income: $114,000 - $45,000 = $69,000. This represents the true net operating income available to the property owner before debt service and capital improvements.
Why the Other Options Are Wrong
Option B: $75,000
Option B ($75,000) incorrectly subtracts operating expenses directly from Potential Gross Income without first accounting for vacancy and collection losses: $120,000 - $45,000 = $75,000. This skips the critical step of calculating Effective Gross Income and overstates the actual NOI by $6,000.
Option C: $114,000
Option C ($114,000) represents only the Effective Gross Income calculation ($120,000 × 0.95) but fails to subtract the operating expenses. This is an incomplete calculation that ignores the significant impact of $45,000 in operating expenses on the property's net income.
Option D: $120,000
Option D ($120,000) is simply the Potential Gross Income with no adjustments whatsoever. This completely ignores both vacancy/collection losses and operating expenses, representing an unrealistic and significantly overstated income figure that would never occur in practice.
PEG-NO Formula
Remember 'PEG-NO': Potential income, subtract Empty spaces (vacancy), subtract General expenses = Net Operating income. Think of a wooden peg with 'NO' written on it - you peg down the potential income by removing vacancy losses and operating expenses.
How to use: When you see an NOI calculation question, immediately think 'PEG-NO' and follow the sequence: start with Potential gross income, subtract Empty space losses (vacancy/collection), subtract General operating expenses to get Net Operating income.
Exam Tip
Always perform NOI calculations in the exact sequence: PGI → EGI → NOI. Write out each step clearly to avoid skipping the vacancy adjustment, which is the most common error on exam questions.
Common Mistakes to Avoid
- -Subtracting operating expenses from Potential Gross Income instead of Effective Gross Income
- -Forgetting to account for vacancy and collection losses entirely
- -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 multi-step process is essential because NOI represents the actual income a property generates after accounting for realistic vacancy rates and necessary operating costs, but before debt service and capital expenditures. Understanding this calculation is crucial for the income approach to valuation, as NOI is typically divided by a capitalization rate to determine property value.
Background Knowledge
Net Operating Income (NOI) 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 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 like apartment buildings, office complexes, or retail centers. The NOI figure is then divided by a market-derived capitalization rate to determine the property's estimated value, making accuracy in this calculation critical for proper valuation.
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