The subject property is a duplex with both units rented at $1,000 per month, while market rent is $1,250 per month per unit. Stabilized vacancy and credit loss is 5% of PGI at either rent level. The owner pays $11,400 a year for property taxes, insurance and maintenance contracts. These costs are at market levels and would not change if rents moved to market. What operating expense ratio, based on EGI, should the appraiser expect at market rent?
Correct Answer
A) 40%
Market PGI is $1,250 × 2 × 12 = $30,000, EGI is $28,500, and the unchanged $11,400 of expenses is 40% of that EGI. The owner's statement ratio of 50% ($11,400 ÷ $22,800) looks high because the rents are low, not because the expenses are. Dividing by contract PGI of $24,000 gives 47.5%, and 60% is the net income ratio at market rent rather than the expense ratio.
Why This Is the Correct Answer
Option A is correct because the $11,400 of expenses does not change while income moves to market. Market PGI is $1,250 × 2 × 12 = $30,000, and a 5% loss leaves EGI of $28,500. The ratio is $11,400 ÷ $28,500 = 40%.
Why the Other Options Are Wrong
Option B: 47.5%
Option B shows 47.5%, which is $11,400 ÷ $24,000, using contract PGI. That uses both the wrong rent level and the wrong income measure; the question asks for the ratio on EGI at market rent, which is $11,400 ÷ $28,500 = 40%.
Option C: 50%
Option C shows 50%, the ratio on the owner's statement: $11,400 ÷ ($24,000 × 0.95) = $11,400 ÷ $22,800. It reflects below-market rents and does not transfer to market rent, where the same dollars are 40% of EGI.
Option D: 60%
Option D shows 60%, which is ($28,500 − $11,400) ÷ $28,500. That is the net income ratio at market rent, the share of EGI left after expenses; the expense ratio is the remaining 40%.
Dollars stay, ratio moves
When rent rises and costs do not, the same dollars become a smaller slice of a bigger income.
How to use: Use this when a statement's expense ratio comes from rents that differ from market.
Exam Tip
If rents are moved to market and the expenses are stated to stay the same, recalculate the ratio on the new EGI. Carrying the old percentage forward would raise the expense dollars without cause.
Common Mistakes to Avoid
- -Applying the statement's percentage to market-rent income
- -Dividing by PGI when the ratio is based on EGI
- -Confusing the operating expense ratio with the net income ratio
Concept Deep Dive
Analysis
This tests how the rent level distorts an expense ratio. The dollars of expense stay put while the income base grows, so the ratio falls as rents move to market. The candidate has to rebuild EGI at market rent and then divide the same $11,400 by the new base.
Background Knowledge
Fixed expenses do not vary with occupancy or use, so a change in rent level changes the expense ratio without changing the expense dollars. A ratio taken from a statement at contract rents can therefore mislead when income is being estimated at market rent. A low-rent property can show a high ratio even when its costs are normal.
Real-World Application
A duplex has long-term tenants paying well under market, and its statement shows half of collected income going to expenses. An appraiser estimating market income holds the taxes, insurance and contracts at their actual market-level dollars. The expense ratio at market rent falls because the same dollars are measured against a larger income.
More Income Approach Questions
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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 estimates annual EGI of $500,000 for an income property. Operating expenses, excluding debt service, are 36% of EGI, and the overall capitalization rate is 8%. What value is indicated?
Next Question
An appraiser is verifying the sale of a 12-unit apartment building that sold for $1,150,000 cash at an 8% overall rate, based on NOI after replacement reserves. Potential gross income is $170,000, vacancy and collection loss is 5% of PGI, the replacement reserve is $4,000, and the buyer's annual debt service is $66,000. What are the implied annual operating expenses before reserves?