The subject property is a triplex in which the owner pays all electricity and water, at a cost of $3,600 a year. The owner plans to install separate meters so that the tenants pay these costs directly and the owner pays none of them. Market evidence shows that similar units with tenant-paid utilities rent for $80 per month less than units with owner-paid utilities. Stabilized vacancy and credit loss is 5% of PGI in either case, and the market overall rate of 8% would not change. Before considering the cost of the meters, what is the effect on indicated value?
Correct Answer
A) An increase of $10,800
Rent falls $80 × 3 × 12 = $2,880, which is $2,736 after the 5% loss, while expenses fall $3,600, so NOI rises $864 and $864 ÷ 0.08 = $10,800. Ignoring vacancy on the lost rent gives a $720 NOI gain and $9,000. Applying the loss to the net $720 gives $8,550. A decrease reverses the direction, because the expense saving exceeds the collected rent given up.
Why This Is the Correct Answer
Option A is correct because the rent given up is $80 × 3 × 12 = $2,880 of potential income, or $2,736 after the 5% loss. The owner saves $3,600 of expenses, so NOI rises $3,600 − $2,736 = $864. At 8%, that is an increase of $864 ÷ 0.08 = $10,800.
Why the Other Options Are Wrong
Option B: An increase of $9,000
Option B shows an increase of $9,000, which is ($3,600 − $2,880) ÷ 0.08. It treats the full $2,880 as lost, although 5% of that rent would not have been collected; the correct NOI gain is $864, giving $10,800.
Option C: An increase of $8,550
Option C shows an increase of $8,550, which is ($3,600 − $2,880) × 0.95 ÷ 0.08. The loss applies to rent and not to the expense saving, so the correct calculation is ($3,600 − $2,736) ÷ 0.08 = $10,800.
Option D: A decrease of $9,000
Option D shows a decrease of $9,000, which treats the $720 difference between saving and gross rent as an NOI loss. The $3,600 saving is larger than the rent given up, so value rises, by $864 ÷ 0.08 = $10,800.
Rent after loss, expense in full
A rent change passes through vacancy and credit loss, while an expense saving reaches NOI dollar for dollar.
How to use: Use this whenever a proposal changes both rent and an owner-paid expense.
Exam Tip
When both rent and expenses change, find the NOI change first and capitalize once. Capitalizing each piece separately works as well, provided the rent piece is taken after loss.
Common Mistakes to Avoid
- -Comparing the expense saving with gross rent instead of collected rent
- -Assuming that lower rent has to mean lower value
- -Applying the loss percentage to the expense saving
Concept Deep Dive
Analysis
This tests a lease-basis change in which income and expense both move. The rent reduction is a potential income figure, so it is reduced for vacancy and credit loss before comparing it with the utility saving. The net NOI change is then capitalized at the unchanged rate.
Background Knowledge
Rent should be estimated on the same pattern of services and expense responsibility as the property being valued. When tenants pay a cost directly, the owner neither receives rent for it nor deducts it. Utilities are a typical variable expense that may shift to tenants through separate metering.
Real-World Application
The owner of a small rental asks whether separate meters are worthwhile. An appraiser finds that tenant-paid units rent for less and compares collected rent given up with the utility bills the owner would stop paying. The capitalized difference can then be compared with the bid for installing the meters.
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?
Annual NOI available for debt service is $168,000 and total annual mortgage principal and interest debt service is $120,000. What is NOI ÷ debt service?
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?
Annual PGI is $360,000 and combined vacancy and collection loss is explicitly 8% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $640,000. Combined vacancy and collection loss is 6.25% of PGI. There is no other income. What EGI remains?
An appraiser is updating a prior appraisal of a triplex with potential gross income of $60,000 and no other income. The prior appraisal used vacancy and credit loss of 5% of PGI, and a new survey of competing rentals indicates 8%. The operating expenses of $24,000 are property taxes, insurance and contract services that do not vary with occupancy, and the market overall rate remains 7.5%. By what percentages do effective gross income and indicated value decrease?
Annual potential rental income is $600,000 and vacancy loss alone is $36,000. What percentage of potential rent does that loss represent?
In the subject's market, lenders on fourplexes have lowered their typical loan-to-value ratio from 70% to 60%. The annual mortgage constant remains 5% and the equity dividend rate remains 10%. The subject's NOI has not changed. How does this affect the overall rate indicated by the band of investment and the indicated value?
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Previous Question
The subject office building has annual potential base rent of $480,000. Tenants also pay the landlord potential expense reimbursements of $120,000 a year, which are not included in the base rent, and pay nothing directly to third-party suppliers. Combined vacancy and collection loss is 8% of both the rent and the reimbursements. What is the annual EGI?
Next Question
In a model where NOI excludes capital expenditures and leasing outlays, and no reserves for them have been deducted, how does cash flow before debt service differ from that NOI?