A property's income stream includes $85,000 in base rents and an estimated $15,000 in reimbursements for property taxes and insurance from tenants (recoveries). Market research indicates a vacancy and collection loss of 8% is typical for similar properties. What is the estimated effective gross income?
Correct Answer
A) $92,000
Correct. The calculation is: Potential Gross Income (PGI) = Base Rent + Recoveries = $85,000 + $15,000 = $100,000. Vacancy and Collection Loss = PGI x Rate = $100,000 x 0.08 = $8,000. Effective Gross Income (EGI) = PGI - Vacancy and Collection Loss = $100,000 - $8,000 = $92,000. This correctly applies the vacancy rate to the total potential income stream, not just the base rent.
Why This Is the Correct Answer
Option A is correct at $92,000. Potential gross income combines the $85,000 in base rents with the $15,000 in tax and insurance recoveries for a total of $100,000, and 8 percent of that is $8,000 of vacancy and collection loss. Subtracting leaves effective gross income of $92,000. Applying the allowance to the full recoverable stream is the right treatment because a vacant suite generates no reimbursement any more than it generates rent, and in fact leaves the landlord absorbing that share of the expense.
Why the Other Options Are Wrong
Option B: $93,200
$93,200 comes from applying the 8 percent allowance only to the $85,000 of base rent, producing $6,800 of loss, and then adding the recoveries back untouched. That treats reimbursements as immune to vacancy, which reverses reality: when a tenant leaves, the landlord loses the recovery and still owes the tax bill. The error understates the loss by $1,200.
Option C: $100,000
$100,000 is potential gross income, the figure before any deduction, so choosing it means stopping one line too early. Effective gross income is defined as potential gross income less vacancy and collection loss, and the stem supplies an 8 percent allowance precisely so the deduction can be made. Skipping the deduction overstates income and, capitalized, would overstate value by roughly 8 percent.
Option D: $102,000
$102,000 does not correspond to any correct step in the income statement and appears to come from adding a percentage rather than subtracting one. Vacancy and collection loss is always a deduction, so effective gross income can never exceed potential gross income. A figure above the $100,000 potential total should be rejected on sight.
Everything a full building collects
Potential gross income is every dollar a fully leased building would collect, rent and recoveries alike. Vacancy takes its bite out of the whole meal, not just the entree, because an empty suite pays nothing at all.
How to use: Total every collectible stream first, then apply the vacancy percentage once to that total. If a choice differs from yours by a small amount, check whether it applied the rate to base rent alone.
Exam Tip
Compute potential gross income before touching the percentage. Most wrong answers in this family come from applying the rate to a partial base rather than from an arithmetic slip.
Common Mistakes to Avoid
- -Applying the vacancy allowance to base rent only
- -Omitting expense recoveries from potential gross income
- -Confusing effective gross income with net operating income
- -Double-counting reimbursed expenses by deducting the full expense after already crediting the recovery
Concept Deep Dive
Analysis
This tests the construction of the income statement through the effective gross income line, and specifically what the vacancy and collection allowance is applied to. Potential gross income is everything the property could collect at full occupancy, and in a commercial property with expense reimbursements that includes both base rent and the recoveries tenants pay for taxes and insurance. Recoveries belong in potential gross income because they are contractual obligations of tenants that rise and fall with occupancy: an empty suite pays neither base rent nor its share of taxes. Since both streams are lost together when a unit goes dark, the vacancy and collection allowance applies to their combined total rather than to base rent alone. The arithmetic here is $85,000 plus $15,000 equals $100,000 of potential gross income, less 8 percent, giving $92,000.
Background Knowledge
You need the income statement sequence from potential gross income through effective gross income to net operating income, and the components that belong on each line. You should also understand expense reimbursements in commercial leases, including how full service, modified gross, and net lease structures determine whether recoveries appear at all, and that vacancy and collection loss is derived from market evidence rather than assumed.
Real-World Application
On a multi-tenant industrial building you build potential gross income from base rents plus estimated common area and tax recoveries, apply a vacancy and collection allowance supported by submarket occupancy data, and then deduct operating expenses net of what tenants reimburse, so no expense is counted twice.
More Income Approach Questions
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