The subject property is a 10,000-sf office building leased on a gross basis, with the landlord paying all operating expenses of $97,000 a year. Similar buildings nearby rent for $24 per square foot annually, with tenants directly paying $2 per square foot of costs that the subject's landlord pays. Stabilized vacancy and credit loss is 5% of PGI, and the market overall rate is 7.5%. What is the indicated value, to the nearest dollar?
Correct Answer
C) $2,000,000
The comparable rents must be restated to the subject's gross basis: $24 + $2 = $26 per square foot, or PGI of $260,000. EGI is $260,000 × 0.95 = $247,000, NOI is $247,000 − $97,000 = $150,000, and $150,000 ÷ 0.075 = $2,000,000. $1,746,667 uses the unadjusted $24, $1,480,000 leaves the rent at $24 and deducts the $2 again as an extra $20,000 expense, and $2,173,333 omits the loss.
Why This Is the Correct Answer
Option C is correct because the subject's landlord pays the $2 of costs that comparable tenants pay directly, so the comparable rent converts to $26 on the subject's gross basis. PGI of $260,000 less the 5% loss is $247,000, and less $97,000 of expenses is $150,000. Dividing by 0.075 indicates $2,000,000.
Why the Other Options Are Wrong
Option A: $1,480,000
Option A, $1,480,000, leaves the rent at $24 and also deducts the $2 costs as an extra expense: $240,000 × 0.95 = $228,000, − $97,000 − $20,000 = $111,000, ÷ 0.075. The $97,000 already includes those costs; the rent adjusts up to $26 and the value is $2,000,000.
Option B: $1,746,667
Option B, $1,746,667, applies the $24 without adjustment: $240,000 × 0.95 = $228,000, − $97,000 = $131,000, ÷ 0.075. This pairs a rent under which tenants pay $2 with an expense total that includes that $2; on a matched basis the value is $2,000,000.
Option D: $2,173,333
Option D, $2,173,333, adjusts the rent correctly but omits the loss: $260,000 − $97,000 = $163,000, ÷ 0.075. The 5% loss must come off PGI first, giving EGI of $247,000 and a value of $2,000,000.
Landlord pays more, rent higher
If the subject's landlord takes on a cost the comparable's tenant pays, add that cost to the comparable's rent. The rent and the expense list must describe the same deal.
How to use: Use this rule to decide whether to add or subtract when converting a comparable rent.
Exam Tip
Before using a comparable rent, ask who pays which expenses. A mismatch between the rent basis and the expense list is a common trap.
Common Mistakes to Avoid
- -Using a comparable rent without checking the lease basis
- -Deducting the tenant-paid costs again as a separate expense
- -Deducting a cost that the rent basis assumes the tenant pays
Concept Deep Dive
Analysis
A rent is only comparable when the same party pays the same expenses. The subject's landlord pays everything, so the rent must be high enough to cover that; the comparable's $24 leaves $2 of those costs with the tenant. Adding the $2 converts the comparable to the subject's basis before any income steps.
Background Knowledge
Lease terms decide who pays operating expenses. Under a gross lease the lessor pays them, under a net lease the lessee pays them, and many leases fall in between. Market rent should reflect the same pattern of services as the subject, so comparable rents on another basis must be adjusted or are not directly comparable.
Real-World Application
An appraiser surveying office rents finds some quoted net of utilities and others fully serviced. To value a fully serviced building, the appraiser converts each quoted rent to the same basis before reaching a conclusion.
More Income Approach Questions
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