A property has annual effective gross income of $520,000 and an operating expense ratio of 28% of EGI. Market data indicate an overall capitalization rate of 7.5%. What value is indicated by direct capitalization, to the nearest dollar?
Correct Answer
D) $4,992,000
NOI is 72% of EGI: $520,000 × 0.72 = $374,400. Capitalizing gives $374,400 ÷ 0.075 = $4,992,000.00. The expense ratio and net income ratio are complements when both are based on EGI. Do not capitalize EGI without the specified operating-expense allowance.
Why This Is the Correct Answer
Option D is correct because NOI is 72% of EGI: $520,000 × 0.72 = $374,400. Dividing by the 7.5% overall rate gives $374,400 ÷ 0.075 = $4,992,000.
Why the Other Options Are Wrong
Option A: $6,933,333
Option A, $6,933,333, capitalizes effective gross income without deducting expenses: $520,000 ÷ 0.075 = $6,933,333. The overall rate applies to NOI of $374,400, giving $4,992,000.
Option B: $374,400
Option B, $374,400, is the NOI ($520,000 × 0.72), not the value. It must still be divided by 0.075 to reach $4,992,000.
Option C: $520,000
Option C, $520,000, is just the effective gross income stated in the problem. It has neither had expenses deducted nor been capitalized; the indicated value is $4,992,000.
One minus expense ratio
If expenses take 28 cents of each EGI dollar, NOI keeps the other 72 cents.
How to use: Use it to turn an expense ratio into NOI in one step.
Exam Tip
When a problem gives an expense ratio, multiply EGI by one minus that ratio before capitalizing.
Common Mistakes to Avoid
- -Capitalizing EGI instead of NOI
- -Reporting NOI as the final value
- -Multiplying EGI by the expense ratio and treating the result as NOI
Concept Deep Dive
Analysis
This question tests converting an operating expense ratio into NOI and then capitalizing NOI. If expenses are 28% of EGI, NOI is the remaining 72% of EGI. That NOI is then divided by the overall rate.
Background Knowledge
The operating expense ratio is operating expenses divided by effective gross income, and the net income ratio is its complement when both use the same EGI base. NOI found this way is capitalized at an overall rate to indicate value.
Real-World Application
An appraiser has an apartment property's EGI and a market-supported expense ratio from comparable operating statements. The appraiser estimates NOI as EGI times the net income ratio and capitalizes it with a market-derived overall rate.
More Income Approach Questions
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Next Question
A broker reports the $2,160,000 cash-equivalent sale of a small retail building with “net income” of $118,800. Verification shows that this figure is after $54,000 of annual debt service on the seller’s loan. The subject property is a similar retail building with annual NOI of $156,000. What is the subject’s indicated value by direct capitalization?