The subject property has annual EGI of $96,000. Expenses other than management total $24,000, and management is an additional 5% of EGI. There are no other deductions. Using an 8% overall rate, what value is indicated by direct capitalization?
Correct Answer
B) $840,000
(96000−24000−96000×0.05)÷0.08 = 840000. Common errors: leaving out the management expense gives $900,000; capitalizing EGI instead of NOI gives $1,200,000; misplacing the decimal in the 8% rate gives $84,000.
Why This Is the Correct Answer
Option B is correct because management is $96,000 × 0.05 = $4,800, so total expenses are $24,000 + $4,800 = $28,800. NOI is $96,000 − $28,800 = $67,200. Capitalizing at 8% gives $67,200 ÷ 0.08 = $840,000.
Why the Other Options Are Wrong
Option A: $84,000
Option A, $84,000, comes from misplacing the decimal in the 8% rate: $67,200 ÷ 0.80 = $84,000. Using 0.08 gives $67,200 ÷ 0.08 = $840,000.
Option C: $900,000
Option C, $900,000, leaves out the management expense: ($96,000 − $24,000) ÷ 0.08 = $900,000. Deducting the $4,800 management fee gives $67,200 ÷ 0.08 = $840,000.
Option D: $1,200,000
Option D, $1,200,000, capitalizes EGI instead of NOI: $96,000 ÷ 0.08 = $1,200,000. Deducting all expenses first gives $67,200 ÷ 0.08 = $840,000.
Management rides on EGI
Compute the management fee as a percent of EGI, add it to the other expenses, and only then divide by the rate.
How to use: Use this when an expense is quoted as a percentage of income rather than a dollar amount.
Exam Tip
Note which income line a percentage expense is based on; here management is a percentage of EGI, not of potential gross income.
Common Mistakes to Avoid
- -Omitting management because it is quoted as a percentage
- -Capitalizing EGI instead of NOI
- -Entering 8% as 0.8 in the division
Concept Deep Dive
Analysis
This question tests deducting a percentage-based management fee along with fixed expenses before capitalizing. The management fee is 5% of EGI and is added to the other expenses to reach NOI. NOI, not EGI, is then divided by the overall rate.
Background Knowledge
Management fees are an operating expense and are often expressed as a percentage of effective gross income. They are deducted along with other operating expenses to reach NOI. Direct capitalization then divides NOI by a compatible overall rate.
Real-World Application
An appraiser reviews a small retail strip where the owner's statement lists taxes, insurance and maintenance but not management. Market data show management typically costs a percentage of EGI. The appraiser adds that fee to expenses before capitalizing NOI.
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Previous Question
An appraiser finds a comparable that sold for a cash-equivalent price of $990,000 with annual EGI of $110,000. The subject has annual EGI of $108,000, measured on the same basis. Sales in the market area indicate the subject would sell at the same price-to-income ratio, with no other adjustments. What is the indicated value of the subject, rounded to the nearest dollar?
Next Question
A comparable sold for a cash-equivalent price of $960,000 and has annual NOI of $80,000. The subject property has annual NOI of $75,000, measured on the same basis. The market indicates the same price-to-income ratio applies to the subject, and no other adjustments are needed. What is the subject's indicated value, rounded to the nearest dollar?