The subject property has annual effective gross income of $112,000 and a net income ratio of 62.5% of EGI. The overall capitalization rate is 8%. What value is indicated by direct capitalization, to the nearest dollar?
Correct Answer
A) $875,000
NOI is 62.5% of EGI: $112,000 × 0.625 = $70,000. Capitalizing gives $70,000 ÷ 0.08 = $875,000.00. The expense ratio and net income ratio are complements when both are based on EGI. Do not capitalize EGI without the specified operating-expense allowance.
Why This Is the Correct Answer
Option A is correct because NOI is $112,000 × 0.625 = $70,000. Capitalizing at 8% gives $70,000 ÷ 0.08 = $875,000. The net income ratio is the complement of the expense ratio on the same EGI base.
Why the Other Options Are Wrong
Option B: $1,400,000
Option B, $1,400,000, capitalizes EGI without deducting expenses: $112,000 ÷ 0.08. NOI must be found first: $112,000 × 0.625 = $70,000, and $70,000 ÷ 0.08 = $875,000.
Option C: $70,000
Option C, $70,000, is the NOI ($112,000 × 0.625) before capitalization. Dividing by the 8% rate gives a value of $875,000.
Option D: $112,000
Option D, $112,000, is simply the effective gross income given in the question. It is neither NOI nor a capitalized value; the indicated value is $112,000 × 0.625 ÷ 0.08 = $875,000.
Ratio to NOI, rate to value
Multiply EGI by the net income ratio to get NOI, then divide NOI by the cap rate to get value.
How to use: Use this when a problem gives EGI and a net income or expense ratio instead of a dollar expense figure.
Exam Tip
If an answer equals EGI divided by the rate, expenses were skipped. Make sure the final figure is a value, not an income.
Common Mistakes to Avoid
- -Capitalizing EGI instead of NOI
- -Stopping at NOI without capitalizing
- -Using the expense ratio in place of the net income ratio
Concept Deep Dive
Analysis
This question tests using a net income ratio to derive NOI from EGI and then capitalizing. NOI is EGI times the net income ratio, and value is NOI divided by the overall rate. The ratio and rate must use the same income base.
Background Knowledge
The net income ratio is NOI divided by effective gross income, and the operating expense ratio is expenses divided by EGI; on the same base they add to 100%. Direct capitalization converts NOI to value by dividing by an overall rate.
Real-World Application
An appraiser uses market expense data showing comparable buildings net about 62.5% of effective gross income. Applying that ratio to the subject's EGI and capitalizing at a market-derived rate gives an income approach indication.
More Income Approach Questions
Which model describes yield capitalization of property benefits?
An appraiser is valuing a duplex. A market survey of recent duplex sales reports prices at 10.8 times potential gross income, with stabilized vacancy and credit loss of 10% of PGI and no other income. The subject's rent schedule is unavailable, but the property manager's records show collected income of $54,000 a year, in line with market rent and the 10% market loss. What value is indicated?
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Previous Question
A property has annual effective gross income of $118,800. Its annual expenses are $43,800, and no other deductions apply. What income remains after deducting those expenses?
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Annual operating expenses are $165,000, excluding debt service. Annual effective gross income is $500,000. Using EGI as the denominator, what operating expense ratio results?