A property has an effective gross income of $120,000 and operating expenses of $45,000. If the overall capitalization rate is 9%, what is the indicated value?
Correct Answer
A) $833,333
First calculate NOI: $120,000 - $45,000 = $75,000. Then apply direct capitalization: $75,000 ÷ 0.09 = $833,333.
Why This Is the Correct Answer
Option A is correct because it follows the proper two-step direct capitalization process. First, we calculate the Net Operating Income (NOI) by subtracting operating expenses from effective gross income: $120,000 - $45,000 = $75,000. Then we apply the direct capitalization formula by dividing NOI by the capitalization rate: $75,000 ÷ 0.09 = $833,333. This represents the present value of the income stream based on the given cap rate.
Why the Other Options Are Wrong
Option B: $1,000,000
This answer ($1,000,000) appears to result from incorrectly dividing the effective gross income by the cap rate ($120,000 ÷ 0.09 = $1,333,333) and then making an additional error, or from using an incorrect cap rate of 7.5% with the correct NOI ($75,000 ÷ 0.075 = $1,000,000).
Option C: $1,333,333
This answer ($1,333,333) results from the common error of using effective gross income instead of net operating income in the capitalization formula ($120,000 ÷ 0.09 = $1,333,333), completely bypassing the necessary step of subtracting operating expenses.
Option D: $1,500,000
This answer ($1,500,000) appears to result from multiple calculation errors, possibly dividing effective gross income by an incorrect cap rate of 8% ($120,000 ÷ 0.08 = $1,500,000) or other mathematical mistakes in the process.
NOI-CAP Memory Formula
Remember 'NICE' - Net Income Capitalized Equals value. The formula is V = NOI ÷ Cap Rate, where NOI = Effective Gross Income - Operating Expenses.
How to use: When you see income approach questions, immediately think 'NICE' and follow the steps: 1) Calculate NOI (subtract expenses from income), 2) Divide by cap rate to get value. Never skip the NOI calculation step.
Exam Tip
Always double-check that you're using NOI (after subtracting operating expenses) and not effective gross income in your capitalization calculation - this is the most common error on these questions.
Common Mistakes to Avoid
- -Using effective gross income instead of net operating income in the capitalization formula
- -Forgetting to subtract operating expenses before applying the cap rate
- -Confusing the cap rate with other rates like discount rates or mortgage rates
Concept Deep Dive
Analysis
This question tests the fundamental income approach calculation using direct capitalization, which is one of the three primary valuation methods in real estate appraisal. The process requires converting effective gross income to net operating income by subtracting operating expenses, then applying the capitalization rate to determine property value. Direct capitalization assumes that the net operating income represents a stabilized annual income that can be capitalized into present value using an appropriate rate. This method is widely used for income-producing properties and requires understanding the relationship between income, expenses, capitalization rates, and property value.
Background Knowledge
Direct capitalization is a valuation method that converts a single year's net operating income into an indication of value by dividing by an appropriate capitalization rate. The capitalization rate represents the relationship between net operating income and property value, typically derived from market sales of comparable properties.
Real-World Application
Appraisers use direct capitalization daily when valuing rental properties, office buildings, and retail centers. They analyze comparable sales to extract market cap rates, then apply these rates to the subject property's stabilized NOI to estimate market value for lending, taxation, or sale purposes.
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