A property's effective gross income is $180,000 with a vacancy rate of 5%. Operating expenses are $65,000. What is the net operating income?
Correct Answer
A) $115,000
If effective gross income is $180,000 (already accounting for vacancy), then NOI = $180,000 - $65,000 = $115,000. Effective gross income already reflects the vacancy adjustment.
Why This Is the Correct Answer
Option A ($115,000) is correct because the calculation properly recognizes that effective gross income already accounts for vacancy losses. Since we start with effective gross income of $180,000, we simply subtract the operating expenses of $65,000 to get NOI. The formula is: NOI = Effective Gross Income - Operating Expenses = $180,000 - $65,000 = $115,000.
Why the Other Options Are Wrong
Option B: $106,000
Option B ($106,000) incorrectly applies the 5% vacancy rate to the effective gross income, double-counting the vacancy adjustment. This suggests confusion between potential gross income and effective gross income calculations.
Option C: $171,000
Option C ($171,000) incorrectly subtracts only the vacancy amount ($9,000) from the effective gross income instead of subtracting the full operating expenses. This demonstrates a fundamental misunderstanding of the NOI calculation.
Option D: $124,000
Option D ($124,000) appears to subtract only a portion of the operating expenses, possibly confusing operating expenses with other expense categories or making an arithmetic error in the calculation process.
EGI-NOI Direct Path
Remember 'EGI to NOI = Subtract OE' (Effective Gross Income to Net Operating Income equals subtract Operating Expenses). Think of EGI as 'money in the door' and NOI as 'money after bills.'
How to use: When you see 'effective gross income' in a problem, immediately recognize that vacancy is already handled - go straight to subtracting operating expenses without any further vacancy calculations.
Exam Tip
Always identify whether the problem gives you 'potential gross income' or 'effective gross income' first - this determines whether you need to calculate vacancy losses or can proceed directly to operating expense deduction.
Common Mistakes to Avoid
- -Double-counting vacancy when effective gross income is already given
- -Confusing potential gross income with effective gross income
- -Including debt service or depreciation in operating expenses
Concept Deep Dive
Analysis
This question tests understanding of the income approach calculation sequence and the critical distinction between potential gross income and effective gross income. Effective gross income is the rental income after vacancy and collection losses have been deducted, representing the actual income the property generates. Net Operating Income (NOI) is calculated by subtracting operating expenses from effective gross income, and is a fundamental metric used in property valuation and investment analysis.
Background Knowledge
The income approach requires understanding the hierarchy: Potential Gross Income → Effective Gross Income (after vacancy/collection losses) → Net Operating Income (after operating expenses). Operating expenses include property taxes, insurance, maintenance, management fees, and utilities, but exclude debt service and depreciation.
Real-World Application
Appraisers use NOI to determine property values through capitalization rates (Value = NOI ÷ Cap Rate). Accurate NOI calculation is essential for investment analysis, loan underwriting, and property valuation in commercial real estate transactions.
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