A property has a Potential Gross Income of $180,000, vacancy and collection loss of 5%, and operating expenses of $54,000. What is the Net Operating Income?
Correct Answer
A) $117,000
Why this is correct: NOI = Potential Gross Income (PGI) - Vacancy & Collection Loss - Operating Expenses. Step 1: Vacancy loss is 5% of $180,000 = $9,000. Effective Gross Income (EGI) = $180,000 - $9,000 = $171,000. Step 2: NOI = EGI - Operating Expenses = $171,000 - $54,000 = $117,000. Why the other choices are wrong: $126,000 is PGI minus expenses but without subtracting vacancy. $171,000 is the EGI, not the NOI. $135,000 is an incorrect calculation (e.g., PGI minus half the expenses). Exam tip: Always calculate vacancy loss first to find EGI before subtracting operating expenses for NOI.
Why This Is the Correct Answer
Option A ($117,000) correctly follows the two-step NOI calculation process. First, the Effective Gross Income is calculated by subtracting vacancy and collection losses from PGI: $180,000 - ($180,000 × 0.05) = $180,000 - $9,000 = $171,000. Then, operating expenses are subtracted from the EGI to arrive at NOI: $171,000 - $54,000 = $117,000. This methodology properly accounts for both revenue losses and operational costs.
Why the Other Options Are Wrong
Option B: $126,000
Option B ($126,000) represents a common error where the vacancy loss is not properly calculated or applied. This might result from incorrectly calculating the 5% vacancy as $5,000 instead of $9,000, leading to an EGI of $175,000 and an NOI of $121,000, or from other computational errors in the sequential calculation process.
Option C: $171,000
Option C ($171,000) represents the Effective Gross Income, not the Net Operating Income. This error occurs when students correctly calculate the first step (PGI minus vacancy losses) but forget to subtract the operating expenses in the second step of the NOI calculation.
Option D: $135,000
Option D ($135,000) likely results from incorrectly subtracting operating expenses directly from PGI without first accounting for vacancy and collection losses. This would yield $180,000 - $54,000 = $126,000, though $135,000 suggests additional calculation errors or misunderstanding of the proper sequence.
PEG-NO Formula
PEG-NO: Potential becomes Effective, then Gets you NOI. P(otential) - E(mpty spaces/vacancy) = G(ross effective), then G(ross) - N(ecessary expenses) = O(perating income)
How to use: When you see an NOI question, think 'PEG-NO' and remember you must first 'PEG' down the vacancy (subtract it from potential to get effective), then subtract expenses to 'GET NO(I)'
Exam Tip
Always perform NOI calculations in the correct sequence: Step 1 - Calculate vacancy loss as a dollar amount, Step 2 - Subtract vacancy from PGI to get EGI, Step 3 - Subtract operating expenses from EGI to get NOI
Common Mistakes to Avoid
- -Forgetting to convert vacancy percentage to dollar amount before subtracting
- -Subtracting operating expenses from PGI instead of EGI
- -Stopping at Effective Gross Income and not completing the NOI calculation
Concept Deep Dive
Analysis
This question tests the fundamental income approach calculation of Net Operating Income (NOI), which is a critical metric in real estate valuation. NOI represents the actual income a property generates after accounting for vacancy losses and operating expenses, but before debt service and capital expenditures. The calculation requires understanding the sequential flow from Potential Gross Income to Effective Gross Income to Net Operating Income. This is one of the most important calculations in commercial real estate appraisal as NOI is used in capitalization rate calculations to determine property value.
Background Knowledge
Net Operating Income is calculated using the formula: NOI = Effective Gross Income - Operating Expenses, where Effective Gross Income = Potential Gross Income - Vacancy and Collection Losses. Operating expenses include items like property taxes, insurance, maintenance, and management fees, but exclude debt service, depreciation, and capital improvements.
Real-World Application
Appraisers use NOI calculations daily when valuing income-producing properties using the income approach. The NOI figure is divided by a market-derived capitalization rate to estimate property value, making accurate NOI calculation essential for reliable property valuations in commercial real estate transactions.
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