The subject property is a small office building cleaned by the owner's affiliated company for $12,000 a year. Unrelated cleaning firms bid $20,000 for the same work. Effective gross income is $180,000 and all other expenses, including property taxes, are at market and total $70,000. Sales of similar buildings indicate an 8% overall rate. What is the indicated value by direct capitalization?
Correct Answer
A) $1,125,000
Expenses are modeled at what a prudent buyer would expect, so the $20,000 market cost replaces the $12,000 affiliate price. NOI = $180,000 − $70,000 − $20,000 = $90,000, and $90,000 ÷ 0.08 = $1,125,000. Using the actual contract gives $1,225,000, averaging the two costs gives $1,175,000, and subtracting the $8,000 gap from value gives $1,217,000.
Why This Is the Correct Answer
Option A is correct because the unrelated bids show what a prudent buyer would expect to pay, so $20,000 is deducted rather than $12,000. NOI is $180,000 − $70,000 − $20,000 = $90,000, and $90,000 ÷ 0.08 = $1,125,000. The owner's discount does not transfer with the property.
Why the Other Options Are Wrong
Option B: $1,175,000
Option B, $1,175,000, averages the two costs to $16,000: ($180,000 − $70,000 − $16,000) ÷ 0.08 = $1,175,000. Averaging gives partial weight to a price a buyer could not expect; the market cost gives $90,000 ÷ 0.08 = $1,125,000.
Option C: $1,217,000
Option C, $1,217,000, capitalizes with the $12,000 contract and subtracts the $8,000 gap once: $98,000 ÷ 0.08 − $8,000 = $1,217,000. The gap recurs annually, so it reduces income before capitalization, which gives $1,125,000.
Option D: $1,225,000
Option D, $1,225,000, uses the affiliate's $12,000 price: ($180,000 − $70,000 − $12,000) ÷ 0.08 = $1,225,000. That overstates income a buyer could expect, because the below-market price is tied to the owner; the correct value is $1,125,000.
Discounts don't convey with deeds
A favor from the owner's own company stays with the owner. The buyer gets the market's price, so the model does too.
How to use: Use this when any expense is paid to a related party or looks far from competing properties.
Exam Tip
Watch for words like affiliated, related or family in an expense description. They signal that the stated cost may need to be replaced with a market figure.
Common Mistakes to Avoid
- -Accepting a related-party price as the market expense
- -Averaging actual and market costs without support
- -Treating a recurring annual gap as a single deduction from value
Concept Deep Dive
Analysis
This tests which of two real numbers belongs in a market-value model. The affiliate price is real cash but reflects a relationship a buyer would not inherit, so the market figure governs. The gap is a recurring cost, so it must flow through income and be capitalized.
Background Knowledge
A property's history is the starting point for expenses, not the conclusion. Related-party arrangements can make costs higher or lower than the market, and comparison with competing properties or unrelated bids reveals the difference. Market-value models use the level a typical buyer would expect.
Real-World Application
While verifying a statement, an appraiser notices that the cleaning contractor shares an address with the owner. Two unrelated bids come in well above the contract price, so the appraiser uses the market level and discloses the adjustment in the report.
More Income Approach Questions
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An appraiser is developing an overall rate for a 40-unit apartment building and has three indications. Five recent, verified sales of similar buildings show rates of 7.5% to 7.7%, centered on 7.6%. A band of investment using typical loan terms and one investor's stated equity dividend rate shows 7.3%. A debt coverage calculation using a lender's minimum ratio, the typical mortgage constant and loan-to-value ratio shows 5.5%. Which rate and reasoning are best?