A property could lawfully and feasibly stay in its current use, with annual net operating income (NOI) of $75,000, or convert to an alternative use with annual NOI of $85,000. The capitalization rate for each use is 8%. Conversion would be immediate at a total cost of $200,000, with no delays or other costs. What is the higher net indicated value of the two uses?
Correct Answer
C) $937,500
Current=75000÷0.08=937500; alternative=85000÷0.08−200000=862500; higher=937500. Common errors: reporting the alternative after costs, which is the lower value gives $862,500; not deducting the conversion costs from the alternative gives $1,062,500; capitalizing only the NOI increase gives $125,000.
Why This Is the Correct Answer
Option C is correct because the current use is worth $75,000 ÷ 0.08 = $937,500, while the alternative is worth $85,000 ÷ 0.08 − $200,000 = $1,062,500 − $200,000 = $862,500. The current use produces the higher net value of $937,500. Conversion costs must be deducted to compare the uses fairly.
Why the Other Options Are Wrong
Option A: $125,000
Option A, $125,000, capitalizes only the NOI increase: ($85,000 − $75,000) ÷ 0.08. That is not a property value; comparing the full net values gives $937,500 for the current use.
Option B: $862,500
Option B, $862,500, is the alternative use after conversion costs ($85,000 ÷ 0.08 − $200,000). It is the lower of the two net values, while the question asks for the higher, $937,500.
Option D: $1,062,500
Option D, $1,062,500, capitalizes the alternative NOI ($85,000 ÷ 0.08) without deducting the $200,000 conversion cost. After costs the alternative is worth $862,500, so the current use at $937,500 is higher.
Net of costs wins
Compare uses only after subtracting what it costs to get there; higher income alone does not make a use more valuable.
How to use: Use this when an alternative use has higher income but requires conversion costs.
Exam Tip
When a question asks for the higher net value, compute both net values fully before choosing.
Common Mistakes to Avoid
- -Ignoring conversion costs when comparing uses
- -Capitalizing only the income difference
- -Choosing the use with higher NOI without comparing net values
Concept Deep Dive
Analysis
This question tests comparing uses on a net value basis, which relates to the financial feasibility element of highest and best use. Each use is capitalized, and conversion costs are deducted from the alternative before comparing. The higher net figure is the answer.
Background Knowledge
Highest and best use requires that a use be legally permissible, physically possible, financially feasible and maximally productive. When comparing a current use with an alternative, the costs to convert must be deducted from the alternative's value.
Real-World Application
An owner considers converting an older office building to apartments, which would raise NOI. The appraiser capitalizes both uses and deducts conversion costs, finding the existing use still yields the higher net value.
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