The operating expense ratio for the subject property is 28% of its annual effective gross income of $525,000. The overall capitalization rate is 9%. What value is indicated by direct capitalization, to the nearest dollar?
Correct Answer
D) $4,200,000
NOI is 72% of EGI: $525,000 × 0.72 = $378,000. Capitalizing gives $378,000 ÷ 0.09 = $4,200,000.00. 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 $525,000 x (1 - 0.28) = $378,000, and $378,000 / 0.09 = $4,200,000. The expense ratio and net income ratio are complements on the same EGI base. Direct capitalization then divides NOI by the overall rate.
Why the Other Options Are Wrong
Option A: $5,833,333
Option A is wrong because $5,833,333 comes from capitalizing EGI without deducting expenses: $525,000 / 0.09 = $5,833,333. The 28% expense allowance must be removed first: $525,000 x 0.72 / 0.09 = $4,200,000.
Option B: $378,000
Option B is wrong because $378,000 is the NOI, not the value. It must still be capitalized: $378,000 / 0.09 = $4,200,000.
Option C: $525,000
Option C is wrong because $525,000 is the effective gross income, not the value. The correct value is $525,000 x 0.72 / 0.09 = $4,200,000.
OER plus NIR equals 100
Operating expense ratio plus net income ratio equals 100% of EGI, so 28% expenses leaves 72% NOI.
How to use: Use this to turn an expense ratio into NOI in one step.
Exam Tip
When a stem gives an expense ratio, convert to the net income ratio before capitalizing. Answers equal to EGI or NOI are intermediate figures, not value.
Common Mistakes to Avoid
- -Capitalizing EGI instead of NOI
- -Stopping at NOI without capitalizing
- -Multiplying EGI by the expense ratio and treating that as NOI
Concept Deep Dive
Analysis
This question tests using an operating expense ratio to derive NOI and then capitalizing. If expenses are 28% of EGI, the net income ratio is 72%. NOI is $525,000 x 0.72 = $378,000, and value is $378,000 / 0.09.
Background Knowledge
The operating expense ratio is operating expenses divided by EGI, and the net income ratio is NOI divided by EGI. When both use the same EGI base, they add up to 100%. Direct capitalization divides NOI by an overall capitalization rate.
Real-World Application
An appraiser finds that comparable apartment properties run expense ratios near 28% of EGI. Applying that ratio to the subject's $525,000 EGI gives $378,000 NOI, which is capitalized at a supported 9% rate.
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