The subject property has annual income before property tax of $80,000. Annual property tax is 0.5% of value. The capitalization rate, excluding the tax component, is 7.5%. What value is indicated by direct capitalization?
Correct Answer
A) $1,000,000
80000÷(0.075+0.005) = 1000000. Common errors: ignoring the effective tax rate gives $1,066,667; subtracting the tax rate instead of adding it gives $1,142,857; deducting 0.5% of income as tax and capitalizing at the base rate gives $1,061,333.
Why This Is the Correct Answer
Option A is correct because the loaded rate is 0.075 + 0.005 = 0.08, and $80,000 ÷ 0.08 = $1,000,000. Adding the effective tax rate to the capitalization rate accounts for a tax that depends on value.
Why the Other Options Are Wrong
Option B: $1,061,333
Option B, $1,061,333, deducts 0.5% of income as tax and capitalizes at the base rate: ($80,000 − $80,000 × 0.005) ÷ 0.075 = $1,061,333. The tax is 0.5% of value, so it belongs in the rate: $80,000 ÷ 0.08 = $1,000,000.
Option C: $1,066,667
Option C, $1,066,667, ignores the effective tax rate: $80,000 ÷ 0.075 = $1,066,667. Since the income is before property tax, the rate must be loaded to 0.08, giving $1,000,000.
Option D: $1,142,857
Option D, $1,142,857, subtracts the tax rate instead of adding it: $80,000 ÷ (0.075 − 0.005) = $1,142,857. The tax is a cost, so it increases the rate: $80,000 ÷ (0.075 + 0.005) = $1,000,000.
Tax on value goes in rate
If the tax depends on the answer (value), you cannot subtract it in dollars first. Put it in the denominator by adding it to the cap rate.
How to use: Use this whenever property tax is given as a percentage of value rather than as a dollar amount.
Exam Tip
Check whether the income is before or after property tax; load the rate only when tax has not already been deducted.
Common Mistakes to Avoid
- -Subtracting the tax rate from the base rate
- -Deducting property tax as an expense and also loading the rate
- -Taking the tax percentage from income instead of value
Concept Deep Dive
Analysis
This question tests loading the capitalization rate with an effective property tax rate. Because tax is a percentage of value rather than a known dollar amount, it is added to the base rate instead of being deducted from income. Value equals income before tax divided by the sum of the two rates.
Background Knowledge
When property taxes are based on value, the tax amount is unknown until value is known. Appraisers can handle this by using income before property tax and a capitalization rate that is the sum of the overall rate and the effective tax rate. Taxes must not be deducted twice, once as an expense and again in the rate.
Real-World Application
An appraiser valuing a property whose taxes will be reset based on the appraised value uses income before taxes and a capitalization rate loaded with the effective tax rate, avoiding a circular estimate of the tax expense.
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?
The subject property is a fourplex with annual EGI of $72,000 and operating expenses of $28,800. Of those expenses, $18,000 is fixed and $10,800 varies in direct proportion to EGI. The owner's annual mortgage payments are $21,000. An appraiser projects that EGI will fall 10% because of higher vacancy. What is the projected NOI?
Annual NOI available for debt service is $168,000 and total annual mortgage principal and interest debt service is $120,000. What is NOI ÷ debt service?
Annual PGI is $250,000 and combined vacancy and collection loss is explicitly 12% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $360,000 and combined vacancy and collection loss is explicitly 8% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $640,000. Combined vacancy and collection loss is 6.25% of PGI. There is no other income. What EGI remains?
An appraiser is updating a prior appraisal of a triplex with potential gross income of $60,000 and no other income. The prior appraisal used vacancy and credit loss of 5% of PGI, and a new survey of competing rentals indicates 8%. The operating expenses of $24,000 are property taxes, insurance and contract services that do not vary with occupancy, and the market overall rate remains 7.5%. By what percentages do effective gross income and indicated value decrease?
Annual potential rental income is $600,000 and vacancy loss alone is $36,000. What percentage of potential rent does that loss represent?
In the subject's market, lenders on fourplexes have lowered their typical loan-to-value ratio from 70% to 60%. The annual mortgage constant remains 5% and the equity dividend rate remains 10%. The subject's NOI has not changed. How does this affect the overall rate indicated by the band of investment and the indicated value?
People Also Study
Real Estate Market
13.6% of exam
Property Description
11.8% of exam
Land or Site Valuation
4.5% of exam
Sales Comparison Approach
16.4% of exam
Cost Approach
13.6% of exam
Previous Question
A model discounts the supported market-minus-contract rent differential on matching expense terms over the remaining lease. What does that isolated present value represent?
Next Question
An appraiser is developing an overall rate for a small residential rental property by the band of investment. Lenders for similar properties have lengthened typical amortization from 25 years to 30 years, with no change in the interest rate or loan-to-value ratio. The equity dividend rate and the subject's NOI are unchanged. How does the change in loan terms affect the income approach?