A property has potential gross income of $120,000, vacancy and collection loss of 5%, and operating expenses of $45,000. What is the Net Operating Income?
Correct Answer
B) $69,000
NOI = (Potential Gross Income - Vacancy & Collection Loss) - Operating Expenses = ($120,000 - $6,000) - $45,000 = $114,000 - $45,000 = $69,000. Vacancy and collection loss is 5% of $120,000 = $6,000.
Why This Is the Correct Answer
Option B ($69,000) correctly applies the NOI formula in the proper sequence. First, calculate the vacancy and collection loss: 5% × $120,000 = $6,000. Then subtract this from potential gross income to get effective gross income: $120,000 - $6,000 = $114,000. Finally, subtract operating expenses from effective gross income: $114,000 - $45,000 = $69,000. This represents the true net operating income available to the property owner.
Why the Other Options Are Wrong
Option A: $75,000
Option A ($75,000) incorrectly calculates NOI by simply subtracting operating expenses from potential gross income without accounting for vacancy and collection losses ($120,000 - $45,000 = $75,000), which overstates the actual income by $6,000.
Option C: $114,000
Option C ($114,000) represents the Effective Gross Income, not the Net Operating Income, as it only accounts for vacancy and collection losses but fails to subtract the $45,000 in operating expenses.
Option D: $120,000
Option D ($120,000) is the Potential Gross Income figure, which represents the theoretical maximum income if the property were 100% occupied with no collection losses or operating expenses, making it completely incorrect for NOI.
PEG-NOI Method
Remember 'PEG-NOI': Potential income → Effective income (subtract vacancy) → Gross operating income → Net Operating Income (subtract expenses). Think of it as 'pegging' down the income step by step until you reach the net amount.
How to use: When you see an NOI calculation question, immediately identify the PEG components: write down Potential income, calculate Effective income by subtracting vacancy percentage, then subtract operating expenses to get NOI.
Exam Tip
Always calculate vacancy and collection losses as a dollar amount first (percentage × potential gross income), then work through the formula step by step rather than trying to do it all at once to avoid calculation errors.
Common Mistakes to Avoid
- -Forgetting to subtract vacancy and collection losses
- -Using potential gross income instead of effective gross income
- -Including debt service or taxes in operating expenses
- -Calculating vacancy percentage incorrectly
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 taxes. The calculation requires understanding the sequential steps: starting with potential gross income, subtracting vacancy and collection losses to get effective gross income, then subtracting operating expenses to arrive at NOI. This metric is essential for determining property value using capitalization rates and cash flow analysis.
Background Knowledge
Net Operating Income is calculated using the formula: NOI = (Potential Gross Income - Vacancy & Collection Loss) - Operating Expenses. The intermediate step (Potential Gross Income - Vacancy & Collection Loss) is called Effective Gross Income, which represents the realistic income expectation before operating costs.
Real-World Application
Appraisers use NOI to determine property values by dividing NOI by market capitalization rates, and investors rely on NOI to evaluate cash flow potential and compare investment properties on an apples-to-apples basis regardless of financing structures.
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