A rental property has potential gross income of $120,000, vacancy and collection loss of 5%, and operating expenses of $35,000. What is the NOI?
Correct Answer
A) $79,000
Effective Gross Income = $120,000 × (1 - 0.05) = $114,000. NOI = $114,000 - $35,000 = $79,000. Net Operating Income is calculated by subtracting operating expenses from effective gross income.
Why This Is the Correct Answer
Option A ($79,000) correctly follows the two-step NOI calculation process. First, the Effective Gross Income is calculated by reducing the Potential Gross Income by the vacancy and collection loss: $120,000 × (1 - 0.05) = $114,000. Then, operating expenses are subtracted from the Effective Gross Income: $114,000 - $35,000 = $79,000. This systematic approach ensures all income adjustments and expenses are properly accounted for in determining the net income available from the property.
Why the Other Options Are Wrong
Option B: $85,000
Option B ($85,000) incorrectly subtracts operating expenses directly from Potential Gross Income without first accounting for vacancy and collection losses: $120,000 - $35,000 = $85,000. This skips the critical step of calculating Effective Gross Income and overstates the actual net operating income by $6,000.
Option C: $114,000
Option C ($114,000) represents only the Effective Gross Income calculation and fails to subtract operating expenses. This figure shows the income after vacancy and collection losses ($120,000 × 0.95 = $114,000) but ignores the requirement to deduct operating expenses to arrive at NOI.
Option D: $80,000
Option D ($80,000) appears to use an incorrect calculation method, possibly applying the vacancy rate incorrectly or making an arithmetic error in the expense deduction. The calculation doesn't follow the proper NOI formula sequence and results in a figure that's $1,000 higher than the correct answer.
PEG-NO Formula
PEG-NO: Potential income → Effective income (subtract vacancy) → Gross operating income → Net Operating income (subtract expenses). Think 'PEG NO' as in 'peg down the numbers step by step, NO shortcuts allowed.'
How to use: When you see an NOI question, immediately think 'PEG-NO' and work through each step: identify Potential income, calculate Effective income by removing vacancy/collection losses, then subtract operating expenses to get Net Operating income.
Exam Tip
Always calculate NOI in two distinct steps on your scratch paper: Step 1 - Calculate Effective Gross Income, Step 2 - Subtract operating expenses. Write out each step to avoid the common mistake of subtracting expenses from potential income.
Common Mistakes to Avoid
- -Subtracting operating expenses directly from potential gross income without calculating effective gross income first
- -Forgetting to account for vacancy and collection losses
- -Including debt service or depreciation as operating expenses in the NOI calculation
Concept Deep Dive
Analysis
This question tests the fundamental income approach calculation of Net Operating Income (NOI), which is a critical metric in real estate valuation. The calculation requires understanding the sequential steps: starting with Potential Gross Income, adjusting for vacancy and collection losses to get Effective Gross Income, then subtracting operating expenses to arrive at NOI. This represents the actual income available to service debt and provide return on investment. NOI is essential for determining property value using capitalization rates and is a key component in investment analysis.
Background Knowledge
Net Operating Income (NOI) is calculated as Effective Gross Income minus Operating Expenses, where Effective Gross Income equals Potential Gross Income minus vacancy and collection losses. Operating expenses include items like maintenance, insurance, property taxes, and management fees, but exclude debt service and depreciation.
Real-World Application
Appraisers use NOI calculations daily when valuing income-producing properties using the income approach. The NOI figure is divided by a market-derived capitalization rate to determine property value, making accuracy in this calculation critical for reliable appraisals and investment decisions.
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