The owner of a four-unit apartment building gives the appraiser an income statement showing effective gross income of $78,000 and these annual deductions: operating expenses of $30,000, including property taxes, insurance and reserves for replacement; mortgage interest of $12,000; tax depreciation of $8,000; and the owner's income tax on the property's earnings of $3,200. The market overall rate is 8%. What is the indicated value by direct capitalization?
Correct Answer
D) $600,000
Only the $30,000 of operating expenses belongs in NOI, so NOI is $78,000 − $30,000 = $48,000 and $48,000 ÷ 0.08 = $600,000. Mortgage interest is a financing cost paid out of NOI, tax depreciation is an accounting charge rather than a cash expense, and income tax relates to the owner, not the property. $450,000, $500,000 and $560,000 each result from deducting one of those items.
Why This Is the Correct Answer
Option D is correct because only the $30,000 of operating expenses reduces NOI, giving $78,000 − $30,000 = $48,000. Dividing by 0.08 indicates $600,000. Mortgage interest, tax depreciation and the owner's income tax do not belong in the income stream that an overall rate capitalizes.
Why the Other Options Are Wrong
Option A: $450,000
Option A, $450,000, deducts mortgage interest: $48,000 − $12,000 = $36,000, ÷ 0.08. Debt service is paid out of net income and reaches the equity cash flow, not NOI, so the value stays at $600,000.
Option B: $500,000
Option B, $500,000, deducts tax depreciation: $48,000 − $8,000 = $40,000, ÷ 0.08. Depreciation on a tax statement is an accounting charge rather than a cash operating outlay, so NOI remains $48,000 and the value $600,000.
Option C: $560,000
Option C, $560,000, deducts the owner's income tax: $48,000 − $3,200 = $44,800, ÷ 0.08. That tax depends on the owner's personal situation and is not a cost of operating the property, so the correct value is $600,000.
Property costs only above NOI
Ask of each line: would any owner of this property pay it, however financed? Interest, tax depreciation and personal income tax fail that test.
How to use: Use this test as you go line by line through an owner's statement.
Exam Tip
Expect an owner's statement to include items that do not belong in NOI. Mark each deduction as operating or not before you subtract anything.
Common Mistakes to Avoid
- -Treating mortgage interest as an operating expense
- -Deducting tax depreciation as though it were a cash cost
- -Capitalizing an owner's reported bottom line without reconstructing it
Concept Deep Dive
Analysis
Owner statements are prepared for the owner's purposes and often include items that are not property operating expenses. The appraiser has to reconstruct them. Each line needs a test: is this a cost of operating the real property, or does it relate to financing, accounting or the owner personally?
Background Knowledge
Reconstructing an operating statement means converting an owner's records into a market-based estimate of income and expenses. Appraisal income and expenses are cash flows, not accounting entries developed on an accrual basis. Debt service falls below NOI, where it separates property income from cash flow to equity.
Real-World Application
An appraiser receives a tax-return schedule showing very low income for a small apartment building. After removing mortgage interest and depreciation from the deductions, the reconstructed NOI is far higher and is consistent with competing properties.
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?
The subject property is a fourplex with annual EGI of $72,000 and operating expenses of $28,800. Of those expenses, $18,000 is fixed and $10,800 varies in direct proportion to EGI. The owner's annual mortgage payments are $21,000. An appraiser projects that EGI will fall 10% because of higher vacancy. What is the projected NOI?
Annual NOI available for debt service is $168,000 and total annual mortgage principal and interest debt service is $120,000. What is NOI ÷ debt service?
Annual PGI is $250,000 and combined vacancy and collection loss is explicitly 12% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $360,000 and combined vacancy and collection loss is explicitly 8% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $640,000. Combined vacancy and collection loss is 6.25% of PGI. There is no other income. What EGI remains?
An appraiser is updating a prior appraisal of a triplex with potential gross income of $60,000 and no other income. The prior appraisal used vacancy and credit loss of 5% of PGI, and a new survey of competing rentals indicates 8%. The operating expenses of $24,000 are property taxes, insurance and contract services that do not vary with occupancy, and the market overall rate remains 7.5%. By what percentages do effective gross income and indicated value decrease?
Annual potential rental income is $600,000 and vacancy loss alone is $36,000. What percentage of potential rent does that loss represent?
In the subject's market, lenders on fourplexes have lowered their typical loan-to-value ratio from 70% to 60%. The annual mortgage constant remains 5% and the equity dividend rate remains 10%. The subject's NOI has not changed. How does this affect the overall rate indicated by the band of investment and the indicated value?
People Also Study
Real Estate Market
13.6% of exam
Property Description
11.8% of exam
Land or Site Valuation
4.5% of exam
Sales Comparison Approach
16.4% of exam
Cost Approach
13.6% of exam
Previous Question
A comparable sold for a cash-equivalent price of $900,000 and has annual PGI of $120,000. The subject property has annual PGI of $110,000. The market indicates the subject would sell at the same price-to-income ratio, and no other adjustments are needed. What value is indicated for the subject, to the nearest dollar?
Next Question
In a stabilized income model, market evidence supports a vacancy allowance despite full occupancy today. Why retain that allowance?