A property has an effective gross income of $120,000 and operating expenses of $45,000. If the capitalization rate is 10%, what is the indicated value using direct capitalization?
Correct Answer
A) $750,000
Net Operating Income = $120,000 - $45,000 = $75,000. Value = NOI ÷ Cap Rate = $75,000 ÷ 0.10 = $750,000.
Why This Is the Correct Answer
Option A is correct because it follows the proper direct capitalization formula: Value = NOI ÷ Cap Rate. First, we calculate Net Operating Income by subtracting operating expenses ($45,000) from effective gross income ($120,000), yielding $75,000. Then we divide this NOI of $75,000 by the capitalization rate of 10% (0.10) to arrive at the indicated value of $750,000. This represents the mathematical relationship that investors expect between annual income and property value in the market.
Why the Other Options Are Wrong
Option B: $1,200,000
Option B ($1,200,000) incorrectly uses the effective gross income instead of net operating income in the capitalization formula, calculating $120,000 ÷ 0.10 = $1,200,000, which ignores the critical step of deducting operating expenses.
Option C: $450,000
Option C ($450,000) appears to result from using only the operating expenses figure ($45,000 ÷ 0.10 = $450,000) or from some other calculation error that doesn't follow the proper direct capitalization methodology.
Option D: $1,650,000
Option D ($1,650,000) likely results from adding the effective gross income and operating expenses ($120,000 + $45,000 = $165,000) and then dividing by the cap rate, which is mathematically incorrect since operating expenses should be subtracted, not added.
NOI-CAP Value Formula
Remember 'VICE' - Value = Income ÷ Cap rate, where Income must be NET (after expenses). Think 'NET before you BET' - always calculate Net Operating Income before applying the cap rate.
How to use: When you see a direct capitalization problem, immediately identify: 1) Effective Gross Income, 2) Operating Expenses, 3) Calculate NOI (subtract expenses), 4) Apply VICE formula (NOI ÷ Cap Rate = Value).
Exam Tip
Always double-check that you're using NET operating income, not gross income, in direct capitalization problems - this is the most common error on exam questions.
Common Mistakes to Avoid
- -Using effective gross income instead of net operating income
- -Adding operating expenses instead of subtracting them
- -Forgetting to convert percentage cap rate to decimal form
Concept Deep Dive
Analysis
This question tests the fundamental income approach concept of direct capitalization, which is one of the three primary methods used in real estate appraisal. Direct capitalization converts a single year's net operating income into an estimate of market value by dividing NOI by an appropriate capitalization rate. The process requires understanding the relationship between effective gross income, operating expenses, and net operating income. This method assumes that the property's income and expenses are stabilized and representative of typical market performance.
Background Knowledge
Direct capitalization is based on the principle that property value equals the annual net operating income divided by the capitalization rate, where the cap rate reflects the relationship between income and value that investors require in the market. Net Operating Income (NOI) is calculated by subtracting all operating expenses from the effective gross income, representing the actual cash flow available to service debt and provide return on investment.
Real-World Application
Appraisers use direct capitalization when valuing income-producing properties like apartment buildings, office buildings, and retail centers, where they analyze comparable sales to extract market capitalization rates and apply them to the subject property's stabilized NOI.
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