An appraiser is valuing a four-unit apartment building and receives the seller's tax-basis income statement, which shows net income of $9,500. That figure is after book depreciation of $7,500, mortgage interest of $11,000 and state income tax of $2,000. All other deductions are normal operating expenses and property taxes. Sales of similar properties indicate an 8% overall rate. What is the indicated value by direct capitalization?
Correct Answer
D) $375,000
Book depreciation, mortgage interest and income tax are not property operating expenses, so all three are added back: $9,500 + $7,500 + $11,000 + $2,000 = $30,000 NOI. Then $30,000 ÷ 0.08 = $375,000. Each wrong figure leaves one item deducted: interest ($237,500), depreciation ($281,250) or income tax ($350,000).
Why This Is the Correct Answer
Option D is correct because depreciation, interest and income tax are all outside property operating expenses and must be added back. NOI is $9,500 + $7,500 + $11,000 + $2,000 = $30,000, and $30,000 ÷ 0.08 = $375,000. The result describes what the property produces, whoever owns or finances it.
Why the Other Options Are Wrong
Option A: $237,500
Option A, $237,500, adds back depreciation and income tax but leaves interest deducted: $19,000 ÷ 0.08 = $237,500. Financing determines how income is divided, not how much the property produces; corrected NOI of $30,000 gives $375,000.
Option B: $281,250
Option B, $281,250, adds back interest and income tax but leaves depreciation deducted: $22,500 ÷ 0.08 = $281,250. Book depreciation is a non-cash accounting charge, so corrected NOI of $30,000 gives $375,000.
Option C: $350,000
Option C, $350,000, adds back depreciation and interest but leaves income tax deducted: $28,000 ÷ 0.08 = $350,000. Income tax depends on the owner's tax position rather than on the property's operations; corrected NOI of $30,000 gives $375,000.
Add back D, I and T
Depreciation, Interest and income Tax belong to the owner's books, not the building's operations. Add all three back to reach NOI.
How to use: Use this when you start from a tax return or an accountant's net income.
Exam Tip
Note whether the facts start at gross income or at a bottom line. From a bottom line, you add items back rather than subtract them.
Common Mistakes to Avoid
- -Capitalizing tax-basis net income without adjustment
- -Leaving mortgage interest deducted because it is a real cash cost
- -Treating book depreciation as an operating expense
Concept Deep Dive
Analysis
Rather than building NOI from the top, you start at the seller's bottom line and reverse the deductions that do not belong. Each one fails for its own reason: depreciation is a non-cash charge, interest reflects financing, and income tax reflects the owner's position. Once all three are added back, the income can be capitalized.
Background Knowledge
NOI measures the income a property produces before financing and before the owner's income taxes. Accounting depreciation spreads a past cost and is not a cash expense of operating the property. Recovery of capital and the effects of income tax are reflected in the capitalization rate.
Real-World Application
A seller gives an appraiser a tax return instead of an operating statement. The appraiser reverses the depreciation, interest and income tax lines to reach NOI and then checks the remaining expenses against 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?
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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?
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