A property has annual potential base rental income of $180,000, with vacancy and collection loss of 5% of base rent. Other real property operating income, already net of its own collection loss, is $25,000. Annual property operating expenses are $56,000, including property taxes and any replacement reserve but excluding debt service. Market data indicate an overall capitalization rate of 10%. What value is indicated, to the nearest dollar?
Correct Answer
A) $1,400,000
Base-rent loss = $180,000 × 0.05 = $9,000. Effective gross income = $180,000 − $9,000 + $25,000 = $196,000. NOI = $196,000 − $56,000 = $140,000. Direct capitalization gives $140,000 ÷ 0.1 = $1,400,000.00, or $1,400,000 to the nearest dollar. The other income is explicitly attributed to the real property, not an unvalued separate business enterprise.
Why This Is the Correct Answer
Option A is correct because the vacancy loss is $180,000 × 0.05 = $9,000, so effective gross income is $180,000 − $9,000 + $25,000 = $196,000. NOI is $196,000 − $56,000 = $140,000. Capitalizing at 10% gives $140,000 ÷ 0.10 = $1,400,000.
Why the Other Options Are Wrong
Option B: $1,800,000
Option B, $1,800,000, results from capitalizing the potential base rent directly: $180,000 ÷ 0.10. It ignores vacancy, other income and operating expenses; the correct NOI of $140,000 ÷ 0.10 gives $1,400,000.
Option C: $1,960,000
Option C, $1,960,000, results from capitalizing effective gross income of $196,000 at 10% instead of NOI. Operating expenses of $56,000 must be deducted first, giving $140,000 ÷ 0.10 = $1,400,000.
Option D: $1,710,000
Option D, $1,710,000, results from capitalizing only the base rent after vacancy: $180,000 × 0.95 = $171,000, then ÷ 0.10. It leaves out the $25,000 other income and the $56,000 expenses; the correct value is $140,000 ÷ 0.10 = $1,400,000.
PGI, EGI, NOI, then divide
Walk the ladder in order: potential, minus vacancy, plus other income, equals effective; minus expenses equals NOI; NOI divided by rate equals value.
How to use: Use this sequence to check that you have not capitalized an income line before NOI.
Exam Tip
Wrong answers in these problems are usually an earlier income line divided by the rate, so write each line out before dividing.
Common Mistakes to Avoid
- -Capitalizing effective gross income instead of NOI
- -Applying the vacancy rate to other income that is already net of its own loss
- -Forgetting to add other income attributable to the real property
Concept Deep Dive
Analysis
This question tests the full income reconstruction from potential gross income to value by direct capitalization. You must deduct vacancy only from base rent, add other income that is already net of its own loss, subtract operating expenses, and then divide NOI by the rate. Each wrong answer stops the process at an earlier line or skips a step.
Background Knowledge
Potential gross income less vacancy and collection loss plus other income gives effective gross income. Operating expenses, including property taxes and reserves but not debt service, are subtracted to reach NOI. Direct capitalization divides NOI by an overall rate derived on a compatible basis.
Real-World Application
An appraiser values a small retail center with base rents, parking income and a supported vacancy rate. The appraiser applies vacancy to base rent, adds the parking income already net of its own loss, and deducts stabilized expenses. The resulting NOI is capitalized at a market-derived overall rate.
More Income Approach Questions
Which model describes yield capitalization of property benefits?
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