The subject property is a medical office building with annual potential base rent of $300,000 and 5% vacancy and collection loss on that rent. Tenants reimburse the landlord $30,000 of building costs a year, stated at collected amounts. The landlord pays $135,000 of annual expenses, including property taxes and the reimbursed costs. Tenants also pay $25,000 of electricity a year directly to the utility. Sales of similar buildings indicate an 8% overall rate. What is the indicated value by direct capitalization?
Correct Answer
C) $2,250,000
EGI = $300,000 × 0.95 + $30,000 = $315,000. The landlord's $135,000 of expenses is deducted, but electricity paid directly by tenants is not a landlord expense, so NOI = $315,000 − $135,000 = $180,000 and $180,000 ÷ 0.08 = $2,250,000. Deducting the electricity gives $1,937,500, leaving out the reimbursements gives $1,875,000, and skipping the 5% vacancy and collection loss gives $2,437,500.
Why This Is the Correct Answer
Option C is correct because EGI of $285,000 + $30,000 = $315,000 less the landlord's $135,000 of expenses leaves NOI of $180,000. The $30,000 of recoveries offsets the $30,000 of reimbursed costs inside the $135,000, and the electricity is not the landlord's cost. Then $180,000 ÷ 0.08 = $2,250,000.
Why the Other Options Are Wrong
Option A: $1,875,000
Option A, $1,875,000, deducts the $135,000 but leaves out the $30,000 of recoveries: ($285,000 − $135,000) ÷ 0.08 = $1,875,000. That charges the landlord for costs that tenants repay; including the recoveries gives $2,250,000.
Option B: $1,937,500
Option B, $1,937,500, deducts the $25,000 of electricity as well: ($315,000 − $135,000 − $25,000) ÷ 0.08 = $1,937,500. Tenants pay that bill directly, so it is neither a receipt nor an expense of the landlord; the correct value is $2,250,000.
Option D: $2,437,500
Option D, $2,437,500, skips the 5% vacancy and collection loss: ($300,000 + $30,000 − $135,000) ÷ 0.08 = $2,437,500. Base rent must be reduced to $285,000 before adding recoveries, which gives $180,000 ÷ 0.08 = $2,250,000.
Trace the dollar, count once
Paid directly by tenants: off the statement. Paid by the landlord and repaid: on both sides, so it nets out once.
How to use: Use this when a property has both reimbursements and tenant-paid utilities.
Exam Tip
Read whether a reimbursed cost is already included in the expense total. That sentence determines whether recoveries are added to income or whether the expenses are already net.
Common Mistakes to Avoid
- -Deducting costs tenants pay directly to suppliers
- -Deducting reimbursed costs without counting the recoveries
- -Leaving out vacancy and collection loss on base rent
Concept Deep Dive
Analysis
Three cost flows have to be traced: costs the landlord bears, costs the landlord pays and recovers, and costs tenants pay directly to suppliers. Tenant-borne costs should not reduce the income to be capitalized. Showing the recoveries as income and the costs as expenses achieves this once, and direct-paid costs stay off the landlord's statement.
Background Knowledge
Lease terms decide who bears each operating cost, from a gross lease, where the lessor pays, to a net lease, where the lessee pays. Costs that tenants pay or reimburse should not reduce the landlord's income to be capitalized. Reimbursements can be shown net or gross, as long as the cost and the recovery offset exactly once.
Real-World Application
An appraiser reads the leases of a medical office building and finds that tenants have separately metered electricity and reimburse building costs. The appraiser excludes the electricity from the expenses, adds recoveries to income and compares the net expense load with similar buildings.
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The subject property is a fourplex with annual EGI of $70,000 and operating expenses equal to 45% of EGI. The owner is signing a new service contract at market terms that will lower operating expenses to 40% of EGI with no change in income. The overall rate for similar properties is 7%. What increase in indicated value results from the lower expenses?
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A lease explicitly allocates the named property taxes, insurance and maintenance to the tenant in addition to base rent. Which description fits these stated conventional terms?