A small commercial building has potential gross income of $120,000 annually. The appraiser analyzes three comparable properties, which have stabilized vacancy and collection losses of 8%, 9%, and 7.5%. The subject property's owner provides records showing a 5% vacancy rate over the past three years due to long-term tenants. What is the appropriate stabilized vacancy and collection loss rate to use in estimating effective gross income?
Correct Answer
B) The average of the three comparable rates, weighted by their similarity to the subject.
Correct. Valuation requires the use of market-derived data. While historical data is informative, the appraiser must analyze the market to develop a stabilized, market-supported rate. The appropriate method is to analyze the rates from comparables, giving more weight to the data from the comparables most similar to the subject in terms of location, age, and tenant profile. A simple average (D) or midpoint (C) is less supportable without an analysis of comparability. Using only the subject's low historical rate (A) ignores market conditions and is not appropriate for a market value appraisal.
Why This Is the Correct Answer
Option B is correct because it derives the rate from market evidence and applies judgment about comparability in doing so. Weighting by similarity is what distinguishes analysis from arithmetic, and it lets a comparable that shares the subject's tenant profile carry more influence than one that does not. This approach also leaves room to conclude toward the lower end of the range if the subject's characteristics genuinely support it, without simply adopting the owner's 5 percent. The conclusion is then supportable and explainable in the report.
Why the Other Options Are Wrong
Option A: 5%, because it is the subject's actual historical experience.
Adopting the owner's historical 5 percent treats one property's experience under one owner's management as though it were the market's expectation. Market value assumes typical rather than actual management, so a rate achievable only under the current arrangement is not the right input. The history should be investigated and may inform where within the market range to conclude, but it cannot displace the range itself.
Option C: The midpoint of the range of comparable rates (7.75%).
The midpoint of 7.75 percent is computed from only the highest and lowest observations and discards the middle one entirely, which is a poorer use of the data than even a simple average. It also involves no assessment of which comparable actually resembles the subject. Choosing a figure because it sits between two endpoints is arithmetic standing in for analysis.
Option D: 8.17%, which is the straight average of the three comparable rates.
A straight average of 8.17 percent treats all three comparables as equally informative, which is almost never true, since one will inevitably match the subject's location, age, or tenancy better than the others. Mechanical averaging also cannot be explained to a reader beyond the calculation itself. The number may end up close to a properly weighted conclusion, but the reasoning behind it would not survive review.
Typical, Not Yours
Market value prices typical operation, not this owner's good luck. A buyer underwrites what the building will do under normal management with normal tenants. So the rate comes from the comparables, and the owner's record only tells you where inside that range to land.
How to use: When a stem contrasts a subject's actual figure with comparable market figures, choose the market-derived option. Then prefer the option that weights the comparables over one that averages them, since weighting reflects analysis. Investigate the subject's history for a real explanation, but do not let it replace market evidence.
Exam Tip
In income approach items, distinguish market value from investment value; the owner's actual experience can drive investment value but not a market value conclusion.
Common Mistakes to Avoid
- -Using the subject's actual vacancy without testing whether it reflects below-market rents
- -Averaging comparable rates mechanically instead of weighting by comparability
- -Applying a stabilized allowance derived from properties with a different tenant or lease profile
Concept Deep Dive
Analysis
This question tests how a stabilized vacancy and collection loss allowance is developed for a market value assignment. Market value asks what a typically motivated buyer would pay, and such a buyer prices the property on what it can be expected to do under typical management and typical tenancy, not on the fortunate experience of the current owner. The subject's 5 percent history is real information and worth investigating, since it may reflect a genuinely superior location, layout, or tenant mix that the market would recognize. But it may equally reflect below-market rents that discourage tenants from leaving, an owner who accepted weak credit to keep space full, or simply a favorable run that will not repeat when the current leases roll. The comparables cluster tightly between 7.5 and 9 percent, which is strong evidence of what the market expects. The correct procedure is to analyze those rates and weight them by how closely each property resembles the subject in location, age, size, tenant profile, and lease structure, rather than defaulting to the subject's own record or to a mechanical average.
Background Knowledge
You need to know the income approach's income build-up, moving from potential gross income through vacancy and collection loss to effective gross income, and that vacancy and collection loss are two distinct components often expressed as one combined allowance. You should also know that market value assumes typical management and typical market participants, and that stabilized inputs are derived from comparable market evidence with the appraiser weighting sources by relevance.
Real-World Application
Analyzing a small office building whose owner reports 5 percent vacancy, an appraiser finds the low figure stems from rents roughly twelve percent under market. Concluding that a buyer paying market price would push rents and see more turnover, the appraiser applies an 8 percent stabilized allowance drawn mainly from the two most similar comparables and explains the reasoning.
More Income Approach Questions
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