A property has potential gross income of $120,000, vacancy and collection loss of 5%, and operating expenses of $35,000. What is the net operating income?
Correct Answer
B) $79,000
NOI = PGI - Vacancy - Operating Expenses. Effective Gross Income = $120,000 - (5% × $120,000) = $114,000. NOI = $114,000 - $35,000 = $79,000.
Why This Is the Correct Answer
Option B correctly follows the two-step NOI calculation process. First, the Effective Gross Income is calculated by subtracting vacancy and collection losses from PGI: $120,000 - ($120,000 × 0.05) = $120,000 - $6,000 = $114,000. Then, operating expenses are subtracted from EGI to determine NOI: $114,000 - $35,000 = $79,000. This systematic approach ensures all income adjustments are properly accounted for before determining the property's net operating performance.
Why the Other Options Are Wrong
Option A: $85,000
This answer incorrectly subtracts operating expenses directly from PGI without first accounting for vacancy and collection losses, resulting in $120,000 - $35,000 = $85,000, which overstates NOI by $6,000.
Option C: $114,000
This represents the Effective Gross Income ($114,000) but fails to subtract the operating expenses, which is a required step to arrive at Net Operating Income.
Option D: $120,000
This is the Potential Gross Income figure without any deductions for vacancy, collection losses, or operating expenses, representing the theoretical maximum income rather than actual net operating performance.
PEG-NOI Formula Chain
Remember 'PEG-NOI': Potential becomes Effective becomes Gross becomes Net Operating Income. Think of it as water flowing downhill - PGI flows down to EGI (minus vacancy), then EGI flows down to NOI (minus operating expenses).
How to use: When you see an NOI calculation question, visualize the PEG-NOI waterfall: start with the highest number (PGI), subtract vacancy to get the middle number (EGI), then subtract operating expenses to reach the bottom (NOI).
Exam Tip
Always calculate EGI first before determining NOI - don't try to subtract both vacancy and operating expenses from PGI in one step, as this increases the chance of calculation errors.
Common Mistakes to Avoid
- -Subtracting operating expenses directly from PGI without first calculating EGI
- -Forgetting to convert the vacancy percentage to a dollar amount before subtracting
- -Confusing EGI with NOI and stopping the calculation too early
Concept Deep Dive
Analysis
This question tests the fundamental income approach calculation for determining Net Operating Income (NOI), which is a critical component in real estate valuation. The calculation requires understanding the sequential flow from Potential Gross Income to Effective Gross Income to Net Operating Income. Students must recognize that vacancy and collection losses are deducted from PGI to get EGI, and then operating expenses are subtracted from EGI to arrive at NOI. This is one of the most frequently tested concepts on appraisal exams because NOI is essential for capitalization rate calculations and property valuations.
Background Knowledge
Net Operating Income represents the actual cash flow a property generates after accounting for vacancy losses and all operating expenses, but before debt service and capital expenditures. It's the foundation for property valuation using the income approach and capitalization rate analysis. Understanding the distinction between PGI, EGI, and NOI is crucial for accurate property valuation and investment analysis.
Real-World Application
Appraisers use NOI calculations daily when valuing income-producing properties like apartment buildings, office complexes, and retail centers. The NOI figure is then divided by a market-derived capitalization rate to determine property value, making accuracy in this calculation critical for reliable appraisals.
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