The annual net operating income (NOI) of a property is $100,000 in its current use and $140,000 in a lawful, feasible alternative use. The capitalization rate for each use is 10%. Conversion would be immediate at a total cost of $800,000, with no delays or other costs. After comparing both uses, what is the higher net indicated value?
Correct Answer
C) $1,000,000
Current=100000÷0.10=1000000; alternative=140000÷0.10−800000=600000; maximum=1000000. Common errors: reporting the alternative after costs, which is the lower value gives $600,000; adding the conversion cost to the alternative instead of deducting it gives $2,200,000; capitalizing only the NOI increase gives $400,000.
Why This Is the Correct Answer
Option C is correct because the current use is worth $100,000 ÷ 0.10 = $1,000,000, while the alternative nets $140,000 ÷ 0.10 − $800,000 = $600,000. The higher net value is $1,000,000 from continuing the current use.
Why the Other Options Are Wrong
Option A: $400,000
Option A, $400,000, comes from capitalizing only the NOI increase (($140,000 − $100,000) ÷ 0.10). That is the gross value gain from conversion, not either use's value; the higher net value is $1,000,000.
Option B: $600,000
Option B, $600,000, is the alternative use after deducting conversion costs ($140,000 ÷ 0.10 − $800,000). It is the lower of the two values, so it is not the higher net indication of $1,000,000.
Option D: $2,200,000
Option D, $2,200,000, adds the $800,000 conversion cost to the alternative's capitalized value ($140,000 ÷ 0.10 + $800,000). Conversion cost is deducted, so the alternative nets $600,000 and the current use at $1,000,000 is higher.
Net of costs, then compare
Value each use, subtract what it costs to get there, and only then pick the bigger number.
How to use: Use net-then-compare whenever a question pits an existing use against a conversion.
Exam Tip
A higher NOI does not settle the question; deduct conversion costs before comparing uses.
Common Mistakes to Avoid
- -Adding conversion costs instead of deducting them when comparing uses
- -Choosing the use with the higher gross income
- -Capitalizing only the income difference
Concept Deep Dive
Analysis
This question tests comparing two feasible uses on a net basis, a highest and best use concept. Each use is capitalized, and conversion costs are deducted from the alternative before comparison. The use that produces the higher net value is the answer.
Background Knowledge
Highest and best use analysis tests uses for legal permissibility, physical possibility, financial feasibility and maximum productivity. When comparing an existing use with a conversion, the costs to convert must be deducted from the alternative's value. The use producing the highest net value is maximally productive.
Real-World Application
An appraiser considers converting an older office building to apartments, which would raise NOI from $100,000 to $140,000 but cost $800,000. After deducting costs, the conversion nets less than the existing use, so the appraiser concludes the current use is maximally productive.
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