A site is leased at a market ground rent of $24,000 per year. The market land capitalization rate is 6%. What land value does ground rent capitalization indicate?
Correct Answer
A) $400,000
Ground rent capitalization divides the ground rent by the land capitalization rate: $24,000 ÷ 0.06 = $400,000. Because ground rent is income to the land alone, nothing is deducted for improvements.
Why This Is the Correct Answer
Option A is correct because ground rent capitalization converts ground rent into land value by dividing by the land capitalization rate. The calculation is $24,000 ÷ 0.06 = $400,000.
Why the Other Options Are Wrong
Option B: $144,000
Option B, $144,000, multiplies the rent by the rate as a whole number: $24,000 × 6 = $144,000. Capitalization divides income by the rate, $24,000 ÷ 0.06 = $400,000.
Option C: $1,440
Option C, $1,440, multiplies the rent by the rate instead of dividing: $24,000 × 0.06 = $1,440. That is a 6% return on the rent, not a value; the correct result is $24,000 ÷ 0.06 = $400,000.
Option D: $40,000
Option D, $40,000, results from a decimal error, dividing by 0.6 instead of 0.06: $24,000 ÷ 0.6 = $40,000. The correct result is $400,000.
IRV: Income over Rate
Value = Income ÷ Rate. Ground rent is the income, the land rate is the rate.
How to use: Use IRV to set up any direct capitalization problem.
Exam Tip
Convert percentages to decimals before dividing, and check that the value is much larger than the annual rent.
Common Mistakes to Avoid
- -Multiplying income by the rate instead of dividing
- -Using 0.6 instead of 0.06 for 6%
- -Deducting building income from ground rent
Concept Deep Dive
Analysis
This question tests ground rent capitalization. Ground rent is income to the land alone, so it is divided directly by the land capitalization rate. No deduction for improvements is needed.
Background Knowledge
Ground rent is paid for the use of land under a ground lease. Capitalizing a market ground rent at a market land capitalization rate indicates land value, using the basic income formula value = income ÷ rate.
Real-World Application
An appraiser values a parcel leased to a restaurant operator under a long-term ground lease at market rent. She derives a land capitalization rate from comparable ground lease sales and divides the rent by it to indicate land value.
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