An appraiser is analyzing a small office building. Market rent is $22 per square foot, and the building has 5,000 rentable square feet. Historically, the property has achieved 100% occupancy, but the appraiser's market study indicates a 7% vacancy and collection loss for comparable properties. There is no other income. What is the estimated annual Effective Gross Income for a market value appraisal?
Correct Answer
A) $102,300
First, calculate Potential Gross Income (PGI): $22/sq.ft. × 5,000 sq.ft. = $110,000 annually. For a market value appraisal, the appraiser must use a market-derived vacancy rate, not the subject's atypical historical performance. Applying the 7% market vacancy and collection loss: $110,000 × 0.07 = $7,700. Effective Gross Income (EGI) = PGI - Vacancy Loss = $110,000 - $7,700 = $102,300.
Why This Is the Correct Answer
Potential gross income of $110,000 less a market-derived 7 percent allowance of $7,700 gives effective gross income of $102,300. Using the market rate rather than the subject's perfect historical record is what makes the figure a stabilized, market value input. A typical buyer would underwrite normal turnover and collection risk regardless of the seller's track record. The result also keeps the income consistent with the properties from which capitalization rates would be extracted.
Why the Other Options Are Wrong
Option B: $110,000
$110,000 is potential gross income with no vacancy deduction, effectively adopting the subject's historical full occupancy as the forecast. That imports one owner's experience into a market value opinion and overstates income. It also skips the step the question asks about, since effective gross income is defined by that deduction.
Option C: $117,700
$117,700 adds the $7,700 vacancy figure rather than subtracting it, which produces an income higher than the property could collect even at full occupancy. Vacancy is always a deduction from potential gross income. A quick check against the $110,000 ceiling rules it out.
Option D: $118,800
$118,800 is $110,000 increased by 8 percent, a rate that appears nowhere in the stem, and moves in the wrong direction besides. No operation on the given figures produces it. Like the previous option, it fails the simple test that effective gross income cannot exceed potential gross income.
Market Rate, Not Owner Record
A perfect occupancy history belongs to the owner, not to the building. Ask what competing properties sustain and use that. The seller's track record is context, never the forecast.
How to use: Compute potential gross income first, then look for the market-derived allowance in the stem and apply it as a subtraction. Reject any option equal to or greater than potential gross income.
Exam Tip
Chronic full occupancy is often a symptom of below-market rent. If a stem mentions it, check whether the rent used is contract or market.
Common Mistakes to Avoid
- -Adopting the subject's historical vacancy instead of a market-derived rate
- -Adding rather than subtracting the vacancy allowance
- -Using contract rent when the assignment calls for a fee simple market value opinion
Concept Deep Dive
Analysis
Two ideas combine in this item. The arithmetic is straightforward: potential gross income is $22 per square foot times 5,000 rentable square feet, or $110,000, and applying a 7 percent vacancy and collection allowance removes $7,700, leaving effective gross income of $102,300. The substantive point is which vacancy rate to use. The subject has achieved full occupancy historically, which is a fact about how this owner has managed this building, perhaps through below-market rents, an unusually stable tenant, or good fortune. A market value opinion asks what a typical purchaser would experience, not what the current owner has experienced, so the stabilized allowance comes from what comparable properties in the same submarket sustain. Using the subject's zero vacancy would overstate effective gross income by $7,700 and, capitalized, would overstate value by many times that amount. The same market-based reasoning governs the rent itself: the appraiser uses market rent of $22 rather than the subject's contract rent when developing a fee simple market value opinion.
Background Knowledge
You need the income build-up from potential gross through effective gross income, the distinction between contract rent and market rent, and the requirement that vacancy and collection loss be derived from market evidence for competing properties. You should also understand why stabilized figures rather than actual owner experience underpin a market value opinion.
Real-World Application
An appraiser valuing a small office building notes the owner's unbroken occupancy record but finds his rents run 8 percent under market. She uses market rent and a market-derived 7 percent allowance, explains why the subject's history was not adopted, and notes that the below-market rents likely explain the occupancy.
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?
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