A property has effective gross income of $120,000 and operating expenses of $45,000. If the capitalization rate is 8.5%, what is the indicated value?
Correct Answer
A) $882,353
Why this is correct: The income capitalization approach values a property by dividing its Net Operating Income (NOI) by a capitalization rate. First, calculate NOI: Effective Gross Income ($120,000) minus Operating Expenses ($45,000) equals $75,000. Then, apply the value formula: Value = NOI / Cap Rate. Substituting the numbers: Value = $75,000 / 0.085 = $882,352.94, which rounds to $882,353. Why the other choices are wrong: "$1,941,176" incorrectly uses the gross income ($120,000) divided by the cap rate ($120,000 / 0.085), omitting the expense deduction. "$1,411,765" might result from using a different, incorrect NOI figure. "$637,500" is the result of multiplying NOI by the cap rate ($75,000 * 0.085), which reverses the proper formula. Exam tip: Always compute NOI first (Income - Expenses). The cap rate goes in the denominator when solving for value: V = NOI / R. If you solve for cap rate, it's R = NOI / V.
Why This Is the Correct Answer
Option A correctly applies the two-step income capitalization process. First, Net Operating Income is calculated by subtracting operating expenses ($45,000) from effective gross income ($120,000), yielding $75,000 NOI. Second, the basic income capitalization formula (Value = NOI ÷ Cap Rate) is applied: $75,000 ÷ 0.085 = $882,353. This demonstrates proper understanding of both NOI calculation and the direct capitalization method.
Why the Other Options Are Wrong
Option B: $1,941,176
This answer likely results from dividing the effective gross income ($120,000) by the cap rate instead of using NOI, yielding $120,000 ÷ 0.085 = $1,411,765. This error ignores operating expenses and fails to calculate proper NOI.
Option C: $1,411,765
This answer appears to result from adding effective gross income and operating expenses ($120,000 + $45,000 = $165,000) then dividing by the cap rate, yielding $1,941,176. This fundamental error misunderstands that operating expenses reduce income rather than add to it.
Option D: $637,500
This answer results from multiplying NOI by the cap rate ($75,000 × 0.085 = $6,375) then applying some other calculation, or possibly dividing effective gross income by a different rate. This demonstrates confusion about the basic capitalization formula direction.
NOI-CAP Value Chain
Remember 'VICE' - Value = Income ÷ Cap rate, where Income means NOI (Net Operating Income). Think of a vice grip squeezing gross income down to NOI by removing expenses, then dividing by cap rate to get value.
How to use: When you see income capitalization problems, immediately think 'VICE' and follow the chain: 1) Calculate NOI (gross income minus expenses), 2) Divide NOI by cap rate to get Value. Always ensure you're using NOI, not gross income.
Exam Tip
Double-check that you're using NOI (after subtracting expenses) and not effective gross income in your cap rate calculation. Write out 'NOI ÷ Cap Rate = Value' to avoid accidentally multiplying instead of dividing.
Common Mistakes to Avoid
- -Using effective gross income instead of NOI in the calculation
- -Multiplying NOI by cap rate instead of dividing
- -Adding operating expenses to income instead of subtracting them
Concept Deep Dive
Analysis
This question tests the fundamental income capitalization approach, one of the three primary valuation methods in real estate appraisal. The income approach converts a property's income stream into an estimate of present value by calculating Net Operating Income (NOI) and dividing by an appropriate capitalization rate. This method is particularly important for income-producing properties like rental buildings, office complexes, and retail centers. Understanding the relationship between NOI, cap rates, and property value is essential for appraisers working with investment properties.
Background Knowledge
The income capitalization approach requires understanding that Net Operating Income (NOI) equals effective gross income minus operating expenses, and that property value equals NOI divided by the capitalization rate. The cap rate represents the relationship between a property's NOI and its market value, typically derived from comparable sales of similar income properties.
Real-World Application
Appraisers use this method daily when valuing rental properties, office buildings, and shopping centers. For example, when appraising a small apartment building, the appraiser would collect rent rolls, estimate vacancy rates, subtract operating expenses like maintenance and property taxes, then apply a market-derived cap rate to determine value for lending or sale purposes.
More Income Approach Questions
A property generates $85,000 in Net Operating Income and sells for $1,062,500. What is the overall capitalization rate?
A property has potential gross income of $180,000, vacancy and collection loss of $15,000, and operating expenses of $65,000. What is the Net Operating Income?
A comparable sale occurred 8 months ago for $425,000. Market conditions indicate property values have increased 0.5% per month since that time. What is the adjusted sale price?
A property generates $150,000 in potential gross income. Market data indicates a 7% vacancy rate and operating expenses of 35% of effective gross income. If the cap rate is 9.5%, what is the indicated value?
A property sold for $320,000 one year ago. If market conditions have improved by 6% since that sale, what is the time-adjusted sale price for comparison purposes?
A commercial building cost $2,500,000 to construct. The land value is $600,000. If the building has suffered 15% physical deterioration and 8% functional obsolescence, what is the depreciated cost of the improvements?
A building's gross rent multiplier (GRM) is 120. If the monthly rent is $2,500, what is the indicated value?
In the cost approach, economic obsolescence is characterized as:
The concept of regression in property values means that:
A commercial property has potential gross income of $120,000, vacancy and collection loss of 8%, and operating expenses of $35,000. Using a cap rate of 9.5%, what is the indicated value?
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