A property's continued use would produce stabilized NOI of $150,000, and conversion would produce NOI of $200,000. Both are capitalized at a 9% direct capitalization rate on the same risk basis. Conversion alone requires an immediate $800,000 payment, and all other costs, risk and timing are already reflected in these figures. Which alternative has the higher net value?
Correct Answer
D) Continue: about $1,666,667 versus $1,422,222 for conversion
Continuation gives $150,000/0.09=$1,666,666.67. Conversion gives $200,000/0.09−$800,000=$1,422,222.22. On these facts, continuation is higher by about $244,444.
Why This Is the Correct Answer
Option D is correct because continuation is worth $150,000 / 0.09 = $1,666,666.67, about $1,666,667. Conversion is worth $200,000 / 0.09 - $800,000 = $1,422,222.22, about $1,422,222. Continuation is higher by about $244,444 under the stated assumptions.
Why the Other Options Are Wrong
Option A: Convert: about $2,222,222 versus $1,666,667 for continuation
Option A, convert at about $2,222,222 versus $1,666,667, capitalizes the conversion NOI ($200,000 / 0.09 = $2,222,222) but omits the required $800,000 payment. Subtracting it gives $1,422,222, which is below the $1,666,667 for continuation.
Option B: Convert: about $2,222,222 versus $866,667 for continuation
Option B, convert at about $2,222,222 versus $866,667 for continuation, subtracts the $800,000 payment from the wrong alternative: $150,000 / 0.09 - $800,000 = $866,667. Only conversion requires the payment, so the correct values are $1,666,667 for continuation and $200,000 / 0.09 - $800,000 = $1,422,222 for conversion.
Option C: Continue: about $150,000 versus $200,000 for conversion
Option C, continue at about $150,000 versus $200,000 for conversion, compares raw NOI figures rather than capitalized values and ignores the $800,000 payment. The correct values are $1,666,667 for continuation and $1,422,222 for conversion.
Capitalize, then subtract costs
Value each use as NOI divided by the cap rate, then subtract any cost needed to get to that use. Compare the net results, not the NOIs.
How to use: Use this two-step order whenever an alternative use requires an upfront payment.
Exam Tip
Higher NOI does not by itself mean higher value when one option carries an upfront cost. Deduct the required expenditure from the alternative that needs it before comparing.
Common Mistakes to Avoid
- -Forgetting to subtract the conversion cost
- -Subtracting the conversion cost from the use that does not require it
- -Comparing NOI instead of capitalized value
Concept Deep Dive
Analysis
This question tests comparing alternatives under the financially feasible and maximally productive tests using direct capitalization. Each NOI is capitalized at 9%, and the $800,000 payment must be subtracted from the conversion value, because only conversion requires it. The alternative with the higher net value is the better use on these facts.
Background Knowledge
Direct capitalization estimates value by dividing NOI by an appropriate capitalization rate. When comparing uses, costs required to achieve an alternative, such as conversion expenditures, must be deducted from that alternative to compare net values. A use must be financially feasible and produce the highest net value to be the highest and best use.
Real-World Application
An appraiser evaluates whether an older office building should be converted to apartments. Although apartment NOI would be higher, the conversion cost is large enough that the net value of continuing as office is greater under the supported assumptions.
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