An appraiser is valuing two ground-leased residential lots. Lot A has a market ground rent of $40,000 per year, no owner expenses and a land capitalization rate of 8%. Lot B has a market ground rent of $44,000 per year, owner expenses of $8,000 per year and a land capitalization rate of 7%. Which lot has the higher value, and by about how much?
Correct Answer
C) Lot B, by about $14,300
Lot A indicates $40,000 ÷ 0.08 = $500,000. Lot B's net income is $44,000 − $8,000 = $36,000, and $36,000 ÷ 0.07 = about $514,300, so Lot B is higher by about $14,300. Ignoring Lot B's expenses gives the $128,600 gap, capitalizing both lots at 8% gives the $50,000 gap, and capitalizing both at 7% gives the $57,100 gap.
Why This Is the Correct Answer
Option C is correct because Lot A's value is $40,000 ÷ 0.08 = $500,000 and Lot B's is ($44,000 − $8,000) ÷ 0.07 = about $514,286. Lot B is therefore higher by about $14,300, even though its net income is lower than Lot A's.
Why the Other Options Are Wrong
Option A: Lot A, by about $50,000
Option A, Lot A by about $50,000, results from capitalizing Lot B's $36,000 at Lot A's 8%: $500,000 − $450,000. Each lot takes its own rate, which puts Lot B ahead by about $14,300.
Option B: Lot A, by about $57,100
Option B, Lot A by about $57,100, results from capitalizing Lot A's $40,000 at Lot B's 7%: $571,429 − $514,286. Lot A's rate is 8%, which gives $500,000 and puts Lot B ahead by about $14,300.
Option D: Lot B, by about $128,600
Option D, Lot B by about $128,600, picks the right lot but ignores the $8,000 of owner expenses: $44,000 ÷ 0.07 = $628,571, less $500,000. Using net income of $36,000 narrows the gap to about $14,300.
Net It, Then Cap It
For each lot, first reduce rent to net income, then divide by that site's own rate. Compare values only after both steps.
How to use: Use this two-step routine when comparing alternatives with different rents, expenses or rates.
Exam Tip
When options name a winner and a margin, solve each alternative fully. Common errors can produce the right winner with the wrong margin.
Common Mistakes to Avoid
- -Comparing the lots on net income without capitalizing it
- -Forgetting to deduct owner-paid expenses from one alternative
- -Applying one site's capitalization rate to both lots
Concept Deep Dive
Analysis
Each lot must be taken through the full method with its own figures. Rent alone does not settle the comparison, because Lot B has lower net income but also a lower rate. The answer comes from computing net income and capitalizing it at the matching rate for each lot.
Background Knowledge
Ground rent capitalization uses market rent less any expenses paid by the owner, capitalized at a market-derived land rate. Differences in expenses and rates can outweigh differences in rent. Each income stream should be paired with the rate appropriate to it.
Real-World Application
An investor is comparing two ground-leased home sites. One offers higher rent, but the owner pays some costs. An appraiser capitalizes the net income from each lot at its own market rate and shows the two values are close.
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Previous Question
Two adjoining parcels are each valued at $130,000 as separate sites. Market data indicate that assembling them would create a plottage premium equal to 15% of the sum of the separate values. What is the indicated value of the assembled site?
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An appraiser is valuing a vacant site near a correctional facility. A comparable vacant site that is not near a prison sold for $520,000. Paired land sales show a discount of $77,000 for proximity to a prison. No other adjustments apply. What is the indicated value of the subject site?