An investor pays $1,400,000 for a property earning $98,000 NOI. A year later, NOI unchanged, similar properties trade at 6.5%. The market says the property is now worth about:
Correct Answer
A) $1,507,700 at the new market rate
Why this is correct: Value is based on current market conditions. The new market cap rate is 6.5%. Using direct capitalization: Value = NOI ÷ Cap Rate. $98,000 ÷ 0.065 = $1,507,692 (approximately $1,507,700). The property's value increased because the market now accepts a lower yield (higher price) for the same income. Why the other choices are wrong: The price paid a year ago is historical cost, not current value. The original implied rate (7%) is no longer the market rate. A 10% cap rate is arbitrary and not supported by the market data given. Exam tip: In income approach, value moves inversely with the cap rate when NOI is stable. A lower cap rate means higher value.
Why This Is the Correct Answer
Dividing the unchanged net operating income by the current market rate is exactly what direct capitalization instructs, and $98,000 divided by 0.065 gives $1,507,692, which rounds to the figure offered. The reasoning matters more than the arithmetic: the appraiser's job is to reflect what buyers and sellers are doing now, and the evidence given is that comparable properties are trading at 6.5 percent. The prior purchase price becomes a data point about last year's market rather than a constraint on this year's opinion. Where the appraiser had reason to think the sale was not arm's length or that the income has changed, those would be separate adjustments to develop.
Why the Other Options Are Wrong
Option B: $1,400,000, the price actually paid
The price actually paid is historical cost, and cost and value coincide only by coincidence, which is one of the first distinctions the appraisal discipline draws. Prices are events; value is an opinion as of an effective date. Anchoring to the purchase price would also make every appraisal a confirmation of the last transaction, which defeats the purpose of the assignment.
Option C: $1,270,000 at the original implied rate
The 7.0 percent implied by last year's purchase describes the market that existed then, and the stem states that similar properties now trade at 6.5 percent. Using the stale rate would produce $1,400,000 again, restating the purchase price under a thin layer of arithmetic. Rates are extracted from current comparable sales, not carried forward from the subject's own history.
Option D: $980,000 at a ten percent standard
Ten percent appears nowhere in the facts and is not supported by any market evidence in the stem, so the resulting $980,000 is an unsupported conclusion. Round numbers that feel like a conservative default are precisely what an appraiser must avoid, since every rate must be extracted or supported. Using it would understate value by more than a third.
Income Over Rate, Rate From The Market
Two moving parts and only one of them belongs to the subject. The income comes from the property; the rate comes from what buyers are paying today. Change the rate and the value moves even when the property has not changed at all.
How to use: For any direct capitalization stem, identify which quantity comes from the subject and which comes from the market, then divide. When a stem mentions a prior purchase price, treat it as a distractor unless the question is specifically about extracting a rate from that sale.
Exam Tip
Value and cap rate move inversely when income is stable. If a stem lowers the rate and holds income constant, the answer must be larger than the prior figure.
Common Mistakes to Avoid
- -Treating the purchase price as evidence of current value rather than as historical data
- -Carrying forward a rate implied by the subject's own prior sale instead of extracting a current one
- -Selecting a round rate by habit rather than supporting it from comparable transactions
Concept Deep Dive
Analysis
This item tests the difference between price paid and value under current market conditions, using direct capitalization to make the point. Value is an opinion developed as of an effective date under the conditions prevailing on that date, so a transaction price from a year ago is historical evidence rather than a current conclusion. Direct capitalization converts a single year's stabilized net operating income into value by dividing by a rate extracted from the market, and the rate is the variable carrying market sentiment about risk and growth. With income held constant at $98,000 and the market now transacting at 6.5 percent, value is $98,000 divided by 0.065, or about $1,507,700. Notice that the original purchase implies a rate of $98,000 divided by $1,400,000, or 7.0 percent, so the market's move from 7.0 to 6.5 percent is what produced the increase.
Background Knowledge
You need the direct capitalization relationship among value, net operating income, and the overall capitalization rate, and the ability to rearrange it in any direction. You should understand that an overall rate is extracted from comparable sales by dividing each sale's net operating income by its price, and that the rate embodies market expectations about risk and income growth. You also need the distinction among cost, price, and value, and the principle that a value opinion is developed as of a stated effective date under the conditions existing then.
Real-World Application
An owner who paid $1,400,000 a year ago asks whether the property is still worth what it cost. The appraiser extracts overall rates from recent sales of similar retail properties, finds them clustered near 6.5 percent, applies that rate to the stabilized net operating income, and reports an indication near $1,508,000, documenting the sales from which the rate was drawn.
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