The subject property is a retail strip center with annual potential rent of $300,000, combined vacancy and collection loss of 10% and no other income. Property management is typical for the market at 6% of collected income. All other expenses, including property taxes, total $100,000 a year. Sales of similar centers indicate an 8% overall rate. What is the indicated value by direct capitalization?
Correct Answer
B) $1,922,500
Collected income is effective gross income: $300,000 × 0.90 = $270,000, so the fee is $270,000 × 0.06 = $16,200. NOI = $270,000 − $100,000 − $16,200 = $153,800, and $153,800 ÷ 0.08 = $1,922,500. Taking the fee on potential rent gives $1,900,000, taking it on income after the other expenses gives $1,997,500, and omitting it gives $2,125,000.
Why This Is the Correct Answer
Option B is correct because collected income is EGI of $300,000 × 0.90 = $270,000, which makes the fee $16,200. NOI is $270,000 − $100,000 − $16,200 = $153,800, and $153,800 ÷ 0.08 = $1,922,500. Because the fee follows collections, it falls when vacancy rises.
Why the Other Options Are Wrong
Option A: $1,900,000
Option A, $1,900,000, takes the fee on potential rent: 6% × $300,000 = $18,000, and ($270,000 − $100,000 − $18,000) ÷ 0.08 = $1,900,000. Managers are paid on collections here, so the fee is $16,200 and the value is $1,922,500.
Option C: $1,997,500
Option C, $1,997,500, takes the fee on income after other expenses: 6% × $170,000 = $10,200, and ($170,000 − $10,200) ÷ 0.08 = $1,997,500. The fee is based on collected income before expenses, so it is $16,200 and the value is $1,922,500.
Option D: $2,125,000
Option D, $2,125,000, omits the fee: $170,000 ÷ 0.08 = $2,125,000. Management is a property operating expense, so $16,200 is deducted and the value is $1,922,500.
Managers get paid on collections
A manager earns a share of the money actually collected. Take vacancy out first, then take the percentage.
How to use: Use this when a fee is stated as a percentage and the facts start from potential income.
Exam Tip
Translate phrases like collected income into the correct income level before calculating. Then check that you took vacancy before computing the fee.
Common Mistakes to Avoid
- -Calculating a percentage fee on potential rent
- -Calculating the fee on income after other expenses
- -Calculating the fee before vacancy and collection loss are taken
Concept Deep Dive
Analysis
A percentage is meaningless until you know its base, and here the words collected income identify it. The fee cannot be calculated until vacancy and collection loss have been taken, so the order of the steps matters. The fee is then deducted along with the fixed expenses before capitalizing.
Background Knowledge
Management fees are commonly quoted as a percentage of effective gross income, which makes them vary with collections. Effective gross income is what remains after vacancy and collection loss. Other expenses may be fixed or vary differently, so each should be estimated on its own basis.
Real-World Application
An appraiser reviewing a retail strip's management agreement sees a fee tied to collected income. When testing a higher vacancy forecast, the appraiser recalculates the fee on the lower collections rather than holding it constant.
More Income Approach Questions
Which model describes yield capitalization of property benefits?
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