The subject property is a neighborhood retail center. Its latest operating statement shows effective gross income of $150,000 and total expenses of $72,000, including $15,000 of uninsured storm cleanup that is finished and paid for and is not expected to recur. The other $57,000 is typical of competing centers. Sales of similar centers indicate an overall rate of 7.5% on stabilized income. What is the indicated value by direct capitalization?
Correct Answer
C) $1,240,000
Direct capitalization converts one year of typical income, so a completed, non-recurring cost is removed from the statement. Normal NOI = $150,000 − $57,000 = $93,000, and $93,000 ÷ 0.075 = $1,240,000. Capitalizing the full $72,000 gives $1,040,000, which treats the one-time cost as permanent. Subtracting the finished cleanup from value gives $1,225,000, and capitalizing effective gross income with no expenses deducted gives $2,000,000.
Why This Is the Correct Answer
Option C is correct because the $15,000 cleanup is complete and will not recur, so only the typical $57,000 is deducted. NOI is $150,000 − $57,000 = $93,000, and $93,000 ÷ 0.075 = $1,240,000. That result reflects the income a typical buyer would project at stabilized operation.
Why the Other Options Are Wrong
Option A: $1,040,000
Option A, $1,040,000, capitalizes the statement as reported: ($150,000 − $72,000) ÷ 0.075 = $1,040,000. That treats a single storm cost as if it recurred each year; the normal figure is $93,000 ÷ 0.075 = $1,240,000.
Option B: $1,225,000
Option B, $1,225,000, normalizes income correctly but then subtracts the cleanup from value: $93,000 ÷ 0.075 − $15,000 = $1,225,000. The work is finished and paid for, so a buyer faces no remaining cost; the value stays at $1,240,000.
Option D: $2,000,000
Option D, $2,000,000, capitalizes effective gross income with no expenses deducted: $150,000 ÷ 0.075 = $2,000,000. Only the one-time cleanup comes out; the $57,000 of typical expenses stays, so the value is $93,000 ÷ 0.075 = $1,240,000.
Capitalize habits, not accidents
An expense you capitalize is an expense you assume happens year after year. A storm that came once and is paid for is an accident, not a habit.
How to use: Use this test on any unusually large line before including it in NOI.
Exam Tip
Read the facts about an unusual cost carefully: is the work finished, and will it recur? Those two facts decide whether it stays in income, is spread over several years or comes out.
Common Mistakes to Avoid
- -Capitalizing a completed one-time cost as though it recurs each year
- -Subtracting a finished, paid-for cost from the value conclusion
- -Capitalizing effective gross income instead of net operating income
Concept Deep Dive
Analysis
This tests the difference between what happened last year and what a buyer expects each year. Capitalizing an expense turns it into a permanent annual burden, so a finished one-time cost has to come out first. After that, the remaining expenses are checked against the market and the normal income is capitalized.
Background Knowledge
A reconstructed operating statement starts from the property's history and adjusts it to what a prudent owner would expect going forward. Items that will not repeat are removed, while irregular items that do repeat are spread over the years they cover. The aim is one representative year that matches the income basis of the capitalization rate.
Real-World Application
An appraiser sees a spike in expenses on a retail center's statement and asks the owner for detail. The invoices show one storm cleanup, now complete, so the appraiser removes it, confirms the remaining expenses against competing centers and capitalizes normal income.
More Income Approach Questions
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A supported price-to-income multiplier of 164 is explicitly defined on the same period and income basis as the subject’s $2,650 income. With no further adjustments, what value is indicated by multiplying the two?
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