The subject property is a retail building leased to one tenant at base rent of $120,000 a year plus overage rent of 5% of annual sales above $1,000,000. Last year's sales were $1,160,000, and the appraiser projects stabilized sales of $1,240,000. Stabilized vacancy and credit loss is 5% of total rent, annual property expenses are $36,300, and the market overall rate is 8%. What is the indicated value of the leased fee interest by direct capitalization?
Correct Answer
D) $1,113,750
Overage rent is 5% × ($1,240,000 − $1,000,000) = $12,000, so total rent is $132,000. EGI is $132,000 × 0.95 = $125,400, NOI is $125,400 − $36,300 = $89,100, and $89,100 ÷ 0.08 = $1,113,750. $971,250 omits the overage rent, $1,066,250 bases it on last year's sales, and $1,035,375 takes the 5% loss twice.
Why This Is the Correct Answer
Option D is correct because overage rent is 5% of the $240,000 of projected sales above the breakpoint, or $12,000, bringing total rent to $132,000. The 5% loss leaves $125,400 and the $36,300 of expenses leaves NOI of $89,100. Dividing by 0.08 indicates $1,113,750.
Why the Other Options Are Wrong
Option A: $971,250
Option A, $971,250, ignores the overage rent: $120,000 × 0.95 = $114,000, − $36,300 = $77,700, ÷ 0.08. Overage rent is part of the rent owed under this lease, so total rent should be $132,000 and the value $1,113,750.
Option B: $1,035,375
Option B, $1,035,375, takes the 5% loss twice: $132,000 × 0.95 × 0.95 = $119,130, − $36,300 = $82,830, ÷ 0.08. One 5% loss applies to total rent, which gives EGI of $125,400 and a value of $1,113,750.
Option C: $1,066,250
Option C, $1,066,250, bases the overage on last year's $1,160,000 of sales: 5% × $160,000 = $8,000, so $128,000 × 0.95 = $121,600, − $36,300 = $85,300, ÷ 0.08. Direct capitalization reflects stabilized income, so the $1,240,000 projection gives overage of $12,000 and a value of $1,113,750.
Excess sales only earn overage
Subtract the breakpoint from sales, then apply the percentage. Sales below the breakpoint earn no overage.
How to use: Use this subtract-then-multiply order on any lease with a percentage clause.
Exam Tip
When two sales figures appear, decide which one represents stabilized operations. The other is usually there to test that judgment.
Common Mistakes to Avoid
- -Applying the percentage to total sales rather than sales above the breakpoint
- -Leaving overage rent out of total rent
- -Using a past sales figure when stabilized sales have been projected
Concept Deep Dive
Analysis
A rent calculation comes before the income steps. Overage rent is paid only on sales above the breakpoint, so the candidate must find the excess, use the projected stabilized sales rather than last year's figure, and add the result to base rent. Only then do the loss, expenses and capitalization follow.
Background Knowledge
Overage rent is percentage rent paid above the guaranteed minimum or base rent, and it is usually tied to a tenant's sales above a set level. Because it depends on sales, an appraiser looks at whether the level of sales is sustainable. Once estimated, it is part of the rental income processed to NOI.
Real-World Application
An appraiser reviews a retail lease with a percentage clause and a tenant whose sales are growing. After checking sales history against similar stores, the appraiser estimates stabilized sales, calculates overage on the excess, and includes it in rental income.
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?
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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?
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