An appraiser is valuing a flex building with effective gross income of $220,000 and operating expenses, including property taxes, of $100,000. The owner's pro forma also lists a $4,000 replacement allowance and a $6,000 recurring leasing allowance. Comparable sales indicate an 8% overall rate, extracted from income after a replacement allowance and with no deduction for recurring leasing costs. What is the indicated value by direct capitalization?
Correct Answer
C) $1,450,000
Income must match how the rate was extracted: after the replacement allowance and before recurring leasing costs, whose effect is already in the rate. NOI = $220,000 − $100,000 − $4,000 = $116,000, and $116,000 ÷ 0.08 = $1,450,000. Deducting both allowances gives $1,375,000, deducting the leasing allowance alone gives $1,425,000, and deducting neither gives $1,500,000.
Why This Is the Correct Answer
Option C is correct because the rate was extracted after a replacement allowance and before recurring leasing costs, and the subject's income must match. NOI is $220,000 − $100,000 − $4,000 = $116,000, and $116,000 ÷ 0.08 = $1,450,000. Leasing costs are already reflected in the rate, so deducting them from income would count them twice.
Why the Other Options Are Wrong
Option A: $1,375,000
Option A, $1,375,000, deducts both allowances: ($220,000 − $100,000 − $10,000) ÷ 0.08 = $1,375,000. The rate already reflects recurring leasing costs, so this double-counts them; the matched result is $116,000 ÷ 0.08 = $1,450,000.
Option B: $1,425,000
Option B, $1,425,000, deducts the $6,000 leasing allowance but not the $4,000 reserve: ($220,000 − $100,000 − $6,000) ÷ 0.08 = $1,425,000. That reverses the rate's basis on both items; the matched result is $1,450,000.
Option D: $1,500,000
Option D, $1,500,000, deducts neither allowance: ($220,000 − $100,000) ÷ 0.08 = $1,500,000. The rate was extracted after a replacement allowance, so income before that allowance is too high for this rate; the matched result is $1,450,000.
Same income, same rate
The rate remembers how it was made. Deduct from the subject what was deducted from the comparables, and nothing else.
How to use: Use this when a pro forma includes allowances that the comparable sales may not have included.
Exam Tip
Find out how the rate was extracted before looking at the expense list. That fact often decides which optional lines to deduct.
Common Mistakes to Avoid
- -Deducting all allowances on a pro forma without checking the rate's basis
- -Deducting recurring leasing costs from income when the rate already reflects them
- -Applying an after-reserve rate to before-reserve income
Concept Deep Dive
Analysis
The arithmetic here depends on consistency. Both allowances are legitimate costs in some models, so the answer depends on how the sales were analyzed. Apply each treatment the rate used: the reserve comes out of income, and the leasing cost stays in the rate.
Background Knowledge
An overall rate describes the relationship between a particular definition of income and price. If an item is not deducted when the rate is extracted, its effect is embedded in the rate. Applying that rate to income defined differently distorts value.
Real-World Application
An appraiser analyzes flex-building sales and finds that buyers underwrote a reserve but not leasing costs. The owner's pro forma deducts both, so the appraiser removes the leasing line from the income to be capitalized and explains why in the report.
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