A rental property has a potential gross income of $120,000, vacancy and collection loss of 5%, and operating expenses of $38,000. If the capitalization rate is 9%, what is the indicated value?
Correct Answer
A) $844,444
Why this is correct: EGI = $120,000 × 95% = $114,000. NOI = $114,000 − $38,000 = $76,000. Value = $76,000 ÷ 9% = $844,444. Why the other choices are wrong: The other choices capitalize gross or effective gross income without correctly subtracting operating expenses. Exam tip: Direct capitalization always uses NOI, not gross income.
Why This Is the Correct Answer
Option C is correct because it follows the proper income capitalization formula. First, we calculate effective gross income: $120,000 × (1 - 0.05) = $114,000. Then we subtract operating expenses to get NOI: $114,000 - $38,000 = $76,000. Finally, we divide NOI by the cap rate: $76,000 ÷ 0.09 = $844,444, which rounds to approximately $800,000 among the given choices.
Why the Other Options Are Wrong
Option B: $1,333,333
$1,333,333 results from dividing the potential gross income ($120,000) directly by the cap rate (0.09) without deducting vacancy losses or operating expenses, which is fundamentally incorrect.
Option C: $1,266,667
$1,266,667 appears to result from dividing the effective gross income ($114,000) by the cap rate without subtracting operating expenses, which omits a crucial step in NOI calculation.
Option D: $911,111
$911,111 appears to be calculated by dividing the gross income by the cap rate without accounting for vacancy/collection losses and operating expenses, or using an incorrect cap rate calculation.
VENO Formula
VENO: Value = Effective income - eXpenses ÷ Net rate. Remember 'VENO' sounds like 'VEIN-O' - think of money flowing through veins, but you must account for blockages (vacancy/expenses) before it reaches the heart (value).
How to use: When you see an income capitalization problem, immediately think VENO: start with gross income, subtract Vacancy losses, subtract EXpenses to get NOI, then divide by the cap rate for value.
Exam Tip
Always work through income capitalization problems step-by-step: write down PGI, subtract V&C losses for EGI, subtract operating expenses for NOI, then divide by cap rate. Double-check that you haven't skipped the vacancy/collection loss step.
Common Mistakes to Avoid
- -Forgetting to subtract vacancy and collection losses from potential gross income
- -Dividing gross income instead of net operating income by the cap rate
- -Including debt service or depreciation as operating expenses when calculating NOI
Concept Deep Dive
Analysis
This question tests the Income Capitalization Approach, one of the three fundamental approaches to real estate valuation. The process involves converting a property's net operating income (NOI) into an estimate of value using a capitalization rate. The key steps are calculating effective gross income by deducting vacancy and collection losses, then subtracting operating expenses to arrive at NOI, and finally dividing by the cap rate. This approach is particularly important for income-producing properties like rental real estate.
Background Knowledge
The Income Capitalization Approach uses the formula: Value = Net Operating Income ÷ Capitalization Rate. Net Operating Income is calculated by starting with potential gross income, subtracting vacancy and collection losses to get effective gross income, then subtracting operating expenses. The capitalization rate represents the rate of return an investor expects from the property.
Real-World Application
Appraisers use this method daily when valuing apartment buildings, office complexes, and retail centers. Investors rely on these calculations to determine maximum purchase prices, and lenders use them to assess loan-to-value ratios for commercial mortgages.
More Income Approach Questions
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