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
A) $69,000
Effective Gross Income = $120,000 × (1 - 0.05) = $114,000. NOI = $114,000 - $45,000 = $69,000.
Why This Is the Correct Answer
Option A ($69,000) correctly follows the two-step NOI calculation process. First, the Effective Gross Income is calculated by reducing the Potential Gross Income by the vacancy and collection loss: $120,000 × (1 - 0.05) = $114,000. Then, operating expenses are subtracted from the Effective Gross Income: $114,000 - $45,000 = $69,000. This systematic approach properly accounts for both income adjustments and expense deductions required to determine true net operating income.
Why the Other Options Are Wrong
Option B: $75,000
Option B ($75,000) incorrectly subtracts operating expenses directly from Potential Gross Income without first accounting for vacancy and collection losses ($120,000 - $45,000 = $75,000). This skips the critical step of calculating Effective Gross Income and overstates the NOI by $6,000.
Option C: $114,000
Option C ($114,000) represents only the Effective Gross Income calculation and fails to subtract operating expenses. This is the intermediate step result ($120,000 × 0.95 = $114,000) but not the final NOI, significantly overstating the net income by the full amount of operating expenses.
Option D: $108,000
Option D ($108,000) appears to subtract only the vacancy loss amount from Potential Gross Income ($120,000 - $6,000 - $6,000 = $108,000) but fails to properly account for operating expenses. This represents a calculation error that doesn't follow the standard NOI formula.
PEG-NO Formula
PEG-NO: Potential income, subtract Empty spaces (vacancy), subtract General expenses = Net Operating income. Think of a PEG (clothespin) holding money, but some falls out from empty spaces, then you pay general expenses, leaving your NET amount.
How to use: When you see an NOI question, immediately think 'PEG-NO' and follow the sequence: start with Potential income, subtract Empty space losses to get Effective income, then subtract General operating expenses to get Net Operating income.
Exam Tip
Always calculate Effective Gross Income first before subtracting operating expenses - never subtract operating expenses directly from Potential Gross Income, as this is a common trap answer choice.
Common Mistakes to Avoid
- -Subtracting operating expenses directly from Potential Gross Income without calculating Effective Gross Income first
- -Forgetting to account for vacancy and collection losses entirely
- -Stopping at Effective Gross Income and not subtracting operating expenses
Concept Deep Dive
Analysis
This question tests the fundamental income approach calculation for determining Net Operating Income (NOI), which is a critical metric in real estate valuation. The calculation requires understanding the sequential steps: starting with Potential Gross Income, adjusting for vacancy and collection losses to get Effective Gross Income, then subtracting operating expenses to arrive at NOI. This is one of the most important calculations in commercial real estate appraisal as NOI is used in capitalization rate calculations and direct capitalization methods. Understanding this formula is essential for income-producing property valuations.
Background Knowledge
Net Operating Income is calculated using the formula: NOI = Effective Gross Income - Operating Expenses, where Effective Gross Income = Potential Gross Income - Vacancy and Collection Losses. This calculation is fundamental to the income approach in real estate appraisal and forms the basis for capitalization rate analysis and property valuation.
Real-World Application
Appraisers use NOI calculations when valuing income-producing properties like apartment buildings, office complexes, or retail centers. The NOI figure is then divided by a market-derived capitalization rate to determine property value, making accurate NOI calculation critical for reliable valuations.
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