The subject property has annual potential rent of $88,000, with combined vacancy and collection loss of 5% of rent only. The owner also collects expense reimbursements of $6,400 per year, with no loss taken against them. Total property expenses of $15,000 include the reimbursed costs and exclude debt service. The overall rate is 10%. What value is indicated by direct capitalization?
Correct Answer
B) $750,000
(88000×0.95+6400−15000)÷0.10 = 750000. Common errors: leaving out the expense reimbursements gives $686,000; not deducting the 5% loss gives $794,000; capitalizing EGI instead of NOI gives $900,000.
Why This Is the Correct Answer
Option B is correct because effective rent is $88,000 × 0.95 = $83,600; adding reimbursements gives $83,600 + $6,400 = $90,000 of EGI; subtracting expenses gives $90,000 − $15,000 = $75,000 of NOI; and $75,000 ÷ 0.10 = $750,000. Direct capitalization converts NOI, not gross income, using the overall rate.
Why the Other Options Are Wrong
Option A: $686,000
Option A, $686,000, leaves out the expense reimbursements: ($88,000 × 0.95 − $15,000) ÷ 0.10 = $686,000. Because the $15,000 of expenses includes the reimbursed costs, the $6,400 of recoveries must be added, giving ($83,600 + $6,400 − $15,000) ÷ 0.10 = $750,000.
Option C: $794,000
Option C, $794,000, fails to deduct the 5% loss: ($88,000 + $6,400 − $15,000) ÷ 0.10 = $794,000. The loss must be taken from potential rent first, so the correct figure is ($83,600 + $6,400 − $15,000) ÷ 0.10 = $750,000.
Option D: $900,000
Option D, $900,000, capitalizes effective gross income instead of NOI: ($83,600 + $6,400) ÷ 0.10 = $900,000. Operating expenses of $15,000 must be deducted before capitalizing, giving $75,000 ÷ 0.10 = $750,000.
Lose, Add, Subtract, Divide
Take the loss off rent, add the effective recoveries, subtract total expenses, then divide by the rate. Skipping any step produces one of the wrong answers.
How to use: Use this four-step order whenever a direct capitalization problem includes vacancy, reimbursements and expenses.
Exam Tip
Note whether the expense total includes reimbursed costs; if it does, the reimbursements belong in income so NOI is not understated.
Common Mistakes to Avoid
- -Omitting tenant reimbursements while still deducting the reimbursed expenses
- -Forgetting to deduct vacancy and collection loss
- -Capitalizing effective gross income instead of NOI
Concept Deep Dive
Analysis
This question tests building NOI in the correct order: apply the loss to potential rent, add already-effective reimbursements, subtract total expenses, then capitalize. The reimbursements must be added because the expense total includes the reimbursed costs. Each step has a matching distractor that skips it.
Background Knowledge
Income processing moves from potential gross income, minus vacancy and collection loss, plus other effective income, to effective gross income, and then subtracts operating expenses to reach NOI. Direct capitalization divides NOI by an overall rate derived on the same income basis.
Real-World Application
An appraiser values a small retail strip where tenants reimburse the landlord for common area costs. The appraiser applies vacancy to base rent, adds the collectible recoveries, deducts the full operating expense budget, and capitalizes the resulting NOI at a market-derived rate.
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
An appraiser is updating appraisals of two duplexes in different market areas, each with unchanged NOI of $33,000. Since the prior appraisals, the overall rate indicated for Duplex A has fallen from 6.0% to 5.5%, and the overall rate indicated for Duplex B has fallen from 10.0% to 9.5%. What is the percentage increase in the indicated value of each duplex?
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Annual principal and interest debt service is $28,800 on an original mortgage principal of $360,000. What annual mortgage constant is annual debt service ÷ original principal?