An appraiser estimates annual EGI of $500,000 for an income property. Operating expenses, excluding debt service, are 36% of EGI, and the overall capitalization rate is 8%. What value is indicated?
Correct Answer
C) $4,000,000
500000×(1−0.36)=320000; 320000÷0.08=4000000. Common errors: capitalizing EGI instead of NOI gives $6,250,000; capitalizing the expenses instead of NOI gives $2,250,000; misplacing the decimal in the 8% rate gives $400,000.
Why This Is the Correct Answer
Option C is correct because NOI = $500,000 × (1 − 0.36) = $320,000, and $320,000 ÷ 0.08 = $4,000,000. Direct capitalization applies the overall rate to NOI.
Why the Other Options Are Wrong
Option A: $400,000
Option A, $400,000, is wrong because it misplaces the decimal in the 8% rate, dividing $320,000 by 0.8 instead of 0.08. The correct result is $320,000 ÷ 0.08 = $4,000,000.
Option B: $2,250,000
Option B, $2,250,000, is wrong because it capitalizes the expenses instead of NOI ($500,000 × 0.36 = $180,000; $180,000 ÷ 0.08 = $2,250,000). The correct base is NOI of $320,000, giving $4,000,000.
Option D: $6,250,000
Option D, $6,250,000, is wrong because it capitalizes EGI without deducting expenses ($500,000 ÷ 0.08 = $6,250,000). Deducting the 36% expenses gives NOI of $320,000 and value of $4,000,000.
One minus expense ratio
NOI equals EGI times (1 − expense ratio); then divide by the cap rate.
How to use: Use this shortcut whenever expenses are given as a percentage of EGI.
Exam Tip
Before dividing, confirm the numerator is NOI and the rate is written as a decimal (8% = 0.08).
Common Mistakes to Avoid
- -Capitalizing EGI instead of NOI
- -Capitalizing the expense amount
- -Treating 8% as 0.8
Concept Deep Dive
Analysis
This question tests converting EGI to NOI with an expense ratio and then capitalizing. Expenses are 36% of EGI, so NOI is 64% of $500,000. NOI divided by 0.08 gives the value.
Background Knowledge
The operating expense ratio is total operating expenses divided by EGI, and one minus that ratio is the net income ratio. An overall capitalization rate extracted from sales is NOI divided by sale price, so it must be applied to NOI.
Real-World Application
An appraiser sees that comparable office buildings run expenses near 36% of EGI. Applying that ratio to the subject's EGI produces NOI, which is then capitalized at a rate extracted from comparable sales.
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Previous Question
An appraiser is estimating stabilized maintenance expense for a rental house. The owner's records show maintenance costs of $3,000 two years ago, $9,000 last year and $3,600 this year. Last year's figure includes $5,100 to clean up after a burst pipe; the cause was corrected, and no recurrence is expected. Maintenance costs on similar rental houses show no clear trend, and the appraiser concludes to the average annual recurring cost. What is the stabilized annual maintenance expense?
Next Question
The subject property is a duplex with both units rented at $1,000 per month, while market rent is $1,250 per month per unit. Stabilized vacancy and credit loss is 5% of PGI at either rent level. The owner pays $11,400 a year for property taxes, insurance and maintenance contracts. These costs are at market levels and would not change if rents moved to market. What operating expense ratio, based on EGI, should the appraiser expect at market rent?