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?
Correct Answer
D) $50,000
Five ratio points of $70,000 add $3,500 of NOI, and $3,500 ÷ 0.07 = $50,000; value moves from $38,500 ÷ 0.07 = $550,000 to $42,000 ÷ 0.07 = $600,000. Taking 5% of the starting value gives $27,500, and 5% of the ending value gives $30,000, both of which treat ratio points on EGI as a percentage of value. Dividing the five points by the 60% ending net income ratio and applying that to the starting value gives $45,833.
Why This Is the Correct Answer
Option D is correct because five points of $70,000 EGI is $3,500 of added NOI, and $3,500 ÷ 0.07 = $50,000. Valuing both cases confirms it: $600,000 − $550,000 = $50,000.
Why the Other Options Are Wrong
Option A: $27,500
Option A, $27,500, is 5% of the starting value: $550,000 × 0.05 = $27,500. The five points apply to EGI, so added NOI is $3,500 and the rise is $3,500 ÷ 0.07 = $50,000.
Option B: $30,000
Option B, $30,000, is 5% of the ending value: $600,000 × 0.05 = $30,000. Ratio points on EGI are not percentage points of value; the rise is $3,500 ÷ 0.07 = $50,000.
Option C: $45,833
Option C, $45,833, uses the 60% ending net income ratio as a base: (5 ÷ 60) × $550,000 = $45,833. The base for a rise is the starting 55% ratio, and the direct result is $3,500 ÷ 0.07 = $50,000.
Capitalize the saving
Turn ratio points into dollars of NOI using EGI, then divide those dollars by the rate.
How to use: Use this shortcut when income or expenses change and the rate stays the same.
Exam Tip
Check which figure a percentage applies to before multiplying. Points of an expense ratio are points of EGI.
Common Mistakes to Avoid
- -Applying the ratio change directly to value
- -Reporting the annual NOI saving as the value change
- -Using the ending ratio as the base for a percentage increase
Concept Deep Dive
Analysis
This item asks for a change in value, so the shortest route is to convert the expense saving into NOI and capitalize just that saving. The five points apply to EGI, not to value. Because the rate is unchanged, each added dollar of NOI adds one dollar divided by the rate.
Background Knowledge
With a fixed overall rate, value changes in proportion to NOI. A modest shift in the expense ratio can therefore move value by much more than the annual saving, because the saving is capitalized.
Real-World Application
An owner asks what a cheaper service contract could add to value before signing it. The appraiser capitalizes the supported annual saving and separately considers whether a market buyer would expect that saving to last.
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Next Question
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?