Market ground rent for a site is a stabilized $48,000 per year, and the landowner pays expenses of $3,000 per year. Market data indicate a land capitalization rate of 6.0%. The rent and the rate both reflect the interest and lease terms being valued. Using ground rent capitalization, what is the indicated land value?
Correct Answer
B) $750,000
Net ground income = $48,000 − $3,000 = $45,000; value = $45,000/0.06 = $750,000. The indicated result is $750,000. Common errors: not deducting the owner expenses gives $800,000; adding the owner expenses instead of deducting them gives $850,000; misplacing the decimal in the 6% rate gives $75,000.
Why This Is the Correct Answer
Option B is correct because net ground income is $48,000 - $3,000 = $45,000, and capitalizing it at 6% gives $45,000 / 0.06 = $750,000. This follows the method of capitalizing market rent less owner expenses at the land capitalization rate. The rent and rate both reflect the interest and lease terms being valued.
Why the Other Options Are Wrong
Option A: $75,000
Option A, $75,000, misplaces the decimal in the 6% rate: ($48,000 - $3,000) / 0.6 = $75,000. The correct divisor is 0.06, giving $45,000 / 0.06 = $750,000.
Option C: $800,000
Option C, $800,000, capitalizes the gross rent without deducting owner expenses: $48,000 / 0.06 = $800,000. Expenses must come off first: $45,000 / 0.06 = $750,000.
Option D: $850,000
Option D, $850,000, adds the owner expenses instead of deducting them: ($48,000 + $3,000) / 0.06 = $850,000. The correct net income is $48,000 - $3,000 = $45,000, and $45,000 / 0.06 = $750,000.
Net first, then divide
Subtract the owner's expenses from rent to get net income, then divide by the rate.
How to use: Use this two-step order on ground rent capitalization problems.
Exam Tip
Check whether the question mentions owner expenses; if it does, deduct them before capitalizing.
Common Mistakes to Avoid
- -Capitalizing gross rent without deducting owner expenses
- -Adding expenses to rent instead of subtracting them
- -Using 0.6 instead of 0.06 for a 6% rate
Concept Deep Dive
Analysis
This question tests the ground rent capitalization method. Market ground rent is first reduced by anticipated owner expenses to find net ground income, which is then divided by the land capitalization rate. Doing the steps in order and writing 6.0% as 0.06 produces the indicated land value.
Background Knowledge
Ground rent capitalization estimates land value by capitalizing market rent, less any expenses the landowner bears, at a land capitalization rate. Because ground leases often leave few expenses to the owner, the deduction may be small but must still be made. The rate should be derived from comparable ground-leased properties.
Real-World Application
A landowner leases a site to a retailer at market rent but still pays some administrative costs. The appraiser deducts those owner expenses from the rent and capitalizes the net amount at a land rate to estimate the fee simple land value.
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