An appraiser is valuing the fee simple interest in a triplex at market rents. A similar triplex sold for $450,000 cash with all units on leases that have four years remaining at rents well below market. Its NOI on those contract rents is $27,000, or 6.0% of the price; at market rents its NOI would be $36,000. Two other sales of similar triplexes leased at market rents indicate overall rates near 7.5%. How should the appraiser treat the 6.0% rate in valuing the subject?
Correct Answer
A) As a leased fee rate on contract income, given little weight unless adjusted
The $450,000 price reflects the rent under the existing leases and the rent increases the buyer expects later, so 6.0% describes a leased fee on contract income. Applying it to the subject's market NOI would overstate value. An arm's-length cash sale does not cure the difference in property rights, and averaging it with the market-rent sales carries the same problem into the result. Dividing market NOI by the price also mismatches the two, because that price was reduced by the leases.
Why This Is the Correct Answer
Option A is correct because the sale conveyed a leased fee, and its price reflects the rent under existing leases. The 6.0% rate relates contract income to that price, so it is not directly applicable to market NOI in a fee simple valuation. It deserves little weight unless the difference in property rights can be adjusted.
Why the Other Options Are Wrong
Option B: As a fee simple rate, since the sale was an arm's-length cash transaction
Option B treats 6.0% as a fee simple rate because the sale was arm's-length and cash. Those facts address the conditions of sale and financing, not the property rights conveyed, and the sale was still subject to four years of below-market leases.
Option C: As one of three rates to be averaged equally with the market-rent sales
Option C averages the 6.0% equally with the rates from the market-rent sales. Averaging gives full weight to a rate on a different income and property rights basis, which would pull the result down and overstate the subject's value.
Option D: As an 8.0% rate after restating its income to market rent at the same price
Option D restates income to market rent and keeps the price, giving $36,000 ÷ $450,000 = 8.0%. That pairs market income with a price held down by the leases, so the 8.0% is not a fee simple rate; market-rent sales here indicate about 7.5%.
Rights first, rate second
Before using a sale's rate, confirm that the sale conveyed the same property rights and the same income level as the subject.
How to use: Use this check whenever a rate from one sale sits far from the rates of the others.
Exam Tip
A rate that stands apart from the others often has an explanation in the facts, such as leases, financing or property type. Identify the reason before you average or discard it.
Common Mistakes to Avoid
- -Applying a contract-income rate to market income
- -Treating an arm's-length cash sale as if it settled the property rights question
- -Mixing a restated income with an unadjusted leased fee price
Concept Deep Dive
Analysis
This tests whether a candidate looks past a sale's clean financing to the property rights it conveyed. A rate is a relationship between income and price, and here both reflect leases the subject's market-rent valuation does not have. The low rate is a sign of below-market income with later rent increases expected, not of a lower market rate for the subject.
Background Knowledge
When contract rent is below market rent, the leased fee is worth less than the fee simple. The sale price of a leased property reflects the rent to be obtained under existing leases. Sales are checked for the property rights conveyed before they are used to support a rate or a value.
Real-World Application
An appraiser finds a small rental property that sold at a very low capitalization rate. Verification shows that the tenants hold several more years at old rents and the buyer is waiting for the leases to expire. The appraiser explains why the rate is not applied to a subject valued at market rent and relies on sales leased at market.
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?
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Previous Question
An appraiser verifying the sale of a fourplex with owner-paid utilities finds a cash equivalent price of $432,000, and the buyer confirms pricing the property at a 7.5% overall rate. Annual PGI at the time of sale was $80,000, and stabilized vacancy and credit loss was 10% of PGI. There is no other income. What operating expense ratio, based on EGI, do these figures indicate?
Next Question
Extracting an overall rate from a comparable sale requires that the comparable's NOI be: