An appraiser is analyzing a property with a single net lease. The lease stipulates the tenant pays $60,000 annual base rent plus all operating expenses, which are estimated at $20,000 per year. Market vacancy for similar properties is 5%. What is the property's estimated Effective Gross Income?
Correct Answer
A) $57,000
Under a net lease, the tenant pays base rent plus operating expenses. The income to the property owner is the base rent. The operating expenses paid by the tenant are not income to the owner; they are a pass-through. Therefore, Potential Gross Income (PGI) is the base rent of $60,000. Applying the 5% market vacancy loss ($60,000 × 0.05 = $3,000) yields an Effective Gross Income (EGI) of $60,000 - $3,000 = $57,000.
Why This Is the Correct Answer
Base rent of $60,000 less a 5 percent vacancy and collection allowance of $3,000 gives effective gross income of $57,000. Tenant-paid operating expenses are excluded from potential gross income because they never constitute income to the owner under this lease structure. Including them would inflate both income and expenses without changing net operating income, and would make the property incomparable to others analyzed on a consistent basis. Applying a market vacancy allowance despite current full occupancy reflects the stabilized, market-based perspective a value opinion requires.
Why the Other Options Are Wrong
Option B: $60,000
$60,000 is the potential gross income with no vacancy deduction, which skips the step that converts potential to effective. Full current occupancy does not justify a zero allowance, because market value assumes a typical purchaser facing normal turnover and rollover risk. The distinction between potential and effective gross income is exactly what the question tests.
Option C: $76,000
$76,000 adds the $20,000 of tenant-paid expenses to base rent and then deducts vacancy, treating pass-through costs as owner income. Under a net lease with direct tenant payment, those dollars are not the landlord's revenue. Even under a reimbursement structure the addition would be matched by an equal expense, leaving net operating income unaffected.
Option D: $80,000
$80,000 adds the operating expenses to base rent and skips the vacancy deduction entirely, combining both errors. It also does not correspond to effective gross income under any lease structure. Two mistakes stacked in one figure make it the least defensible option.
Only What Reaches the Landlord
Potential gross income counts dollars the owner has a right to collect. Money the tenant pays straight to the tax collector or the insurer never touches the owner's hand and never enters the income line.
How to use: Trace each dollar in the stem to whoever receives it. Owner receipts go into potential gross income; direct third-party payments by the tenant do not. Then always apply the market vacancy allowance.
Exam Tip
Apply a market vacancy allowance even when occupancy is currently 100 percent. Market value reflects typical expectations over a stabilized period, not the current lease's certainty.
Common Mistakes to Avoid
- -Adding tenant-paid operating expenses to potential gross income
- -Omitting the vacancy allowance on a fully occupied property
- -Comparing a net-lease income stream to capitalization rates extracted from gross-lease properties
Concept Deep Dive
Analysis
Under a net lease the tenant pays base rent to the landlord and pays operating expenses either directly to the vendors or as a reimbursement to the landlord. Where the tenant pays directly, as this stem describes, those dollars never pass through the landlord's income statement at all, so they are neither income nor expense to the property owner. Potential gross income is therefore the $60,000 base rent alone. Applying the 5 percent market vacancy and collection loss allowance removes $3,000, leaving effective gross income of $57,000. Two related points are worth holding. First, if the lease instead required the tenant to reimburse the landlord, the reimbursement would appear as income and the corresponding expense would appear as an expense, grossing up both sides while leaving net operating income unchanged. Second, the appraiser must apply a market vacancy allowance even on a fully occupied single-tenant property, because market value contemplates the risk of the tenant eventually leaving rather than the certainty of the current lease.
Background Knowledge
You need the income build-up from potential gross through effective gross to net operating income, and the lease structure spectrum from full service gross through single, double, and triple net. You should also know the difference between tenant-paid expenses and expense reimbursements and why the two are presented differently on an operating statement.
Real-World Application
An appraiser valuing a single-tenant net-leased building confirms from the lease that the tenant pays taxes, insurance, and maintenance directly. She builds potential gross income from base rent only, applies a market vacancy allowance reflecting rollover risk, and selects capitalization rate comparables with matching lease structures.
More Income Approach Questions
In a percentage lease, rent is commonly structured as:
In a DCF, what is the reversion?
Potential gross income differs from effective gross income in that PGI assumes:
The reversion in a discounted cash flow model represents:
Building A (new, credit tenant, 20-year lease) and Building B (older, month-to-month tenants) sell the same week. Their cap rates should differ how?
An overall rate extracted from a sale whose NOI excluded reserves, applied to a subject NOI that includes them, will:
Replacement reserves cover which kind of expenditure?
What is the primary distinction, for appraisal purposes, between 'vacancy loss' and 'collection loss'?
An appraiser is analyzing a mixed-use property with retail and office components. The retail segment has a potential gross income of $180,000 with a market vacancy of 8%. The office segment has a potential gross income of $120,000 with a market vacancy of 12%. What is the overall effective gross income for the property?
The mortgage constant represents:
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