The subject property is a two-story mixed-use building. The owner operates a bakery on the 6,000-sf ground floor and pays no rent; last year the bakery earned a net profit of $88,000. The upper floor is leased as offices at market rent totaling $84,000 a year. Similar ground-floor retail space rents for $12 per square foot annually on the same expense terms as the offices. Stabilized vacancy and credit loss is 5% of PGI, real property operating expenses are $52,200, excluding the bakery's own costs, and the market overall rate is 8%. What is the indicated value of the fee simple interest?
Correct Answer
A) $1,200,000
The bakery's profit is business income, so it comes out and the ground floor is given its market rent of 6,000 × $12 = $72,000. PGI is $156,000, EGI is $148,200, NOI is $96,000, and $96,000 ÷ 0.08 = $1,200,000. Capitalizing the bakery profit in place of rent gives $1,390,000. Leaving the imputed rent out of the loss calculation gives $1,245,000, and taking no loss at all gives $1,297,500.
Why This Is the Correct Answer
Option A is correct because the ground floor is valued at its market rent of 6,000 × $12 = $72,000, not at the bakery's profit. PGI of $84,000 + $72,000 = $156,000 less 5% gives EGI of $148,200. Deducting $52,200 leaves NOI of $96,000, and $96,000 ÷ 0.08 = $1,200,000.
Why the Other Options Are Wrong
Option B: $1,245,000
Option B shows $1,245,000, which is ($84,000 × 0.95 + $72,000 − $52,200) ÷ 0.08. Imputed rent is potential income and carries the same 5% loss as other rent, so the correct NOI is $96,000 and the value is $1,200,000.
Option C: $1,297,500
Option C shows $1,297,500, which is ($156,000 − $52,200) ÷ 0.08. It treats PGI as if all of it would be collected; after the 5% loss, NOI is $96,000 and the value is $1,200,000.
Option D: $1,390,000
Option D shows $1,390,000, which is (($84,000 + $88,000) × 0.95 − $52,200) ÷ 0.08. It treats the bakery's $88,000 profit as if it were rent, which capitalizes business earnings into real property value; the market rent is $72,000.
Value the space, not the bakery
Ask what a tenant would pay for the space, and leave the owner's business profit out of the income.
How to use: Use this whenever an owner runs a business in part of the property being appraised.
Exam Tip
An owner paying no rent does not mean the space has no income. Impute market rent, and let it share the same vacancy and credit loss as the other potential income.
Common Mistakes to Avoid
- -Capitalizing an owner's business profit as if it were real property income
- -Leaving out income for owner-occupied space because no rent is paid
- -Omitting vacancy and credit loss from imputed rent
Concept Deep Dive
Analysis
This tests the difference between business income and real property income in an owner-occupied building. The value of the real property depends on what the ground floor would rent for, not on how well the owner runs a bakery. The candidate removes the profit, imputes market rent and processes that rent with the office rent.
Background Knowledge
Income from operating a business depends in part on management skill and on assets other than the real estate. Rental income is generally the better measure of what the real property earns. For owner-occupied space, rent can often be imputed from comparable rentals.
Real-World Application
A restaurant owner asks for an appraisal of the building that houses the restaurant and two leased offices. The owner supplies the restaurant's profit-and-loss statement. The appraiser sets it aside for income purposes, surveys rents for similar space and imputes market rent to the restaurant area.
More Income Approach Questions
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