When applying single-period direct capitalization, what is important about the income and overall rate?
Correct Answer
A) The income is representative and the rate matches its income definition.
A representative income and a compatible market rate are necessary for meaningful capitalization. Rates can embody expectations; a single-year method does not require every future cash flow to be literally level. Material lease-up or unusual costs need appropriate treatment rather than being ignored.
Why This Is the Correct Answer
Option A is correct because direct capitalization is meaningful only when the single-year income is representative and the overall rate is derived on a compatible income definition. A rate drawn from the market can reflect expectations about future benefits, so it must match the income it is applied to.
Why the Other Options Are Wrong
Option B: Income is assumed to grow at precisely the inflation rate, so the rate excludes growth.
Option B claims income is assumed to grow at precisely the inflation rate and that the rate excludes growth. Market-derived rates can embody growth expectations, and direct capitalization makes no such fixed inflation assumption.
Option C: An independent audit of each income statement is required by USPAP.
Option C claims USPAP requires an independent audit of each income statement. USPAP requires credible, supported analysis, but it does not require audited statements.
Option D: Percentage rent and expense recoveries are excluded from income, even when typical.
Option D excludes percentage rent and expense recoveries from income even when typical. Typical, supportable income items belong in the income estimate when the rate was derived on the same basis.
Representative income, matching rate
Direct capitalization works when a typical year's income is paired with a rate built on the same income definition.
How to use: Use this pairing test when judging whether a cap rate application is valid.
Exam Tip
Watch for answers that add precise growth assumptions or audit requirements; the core test is representative income and a compatible rate.
Common Mistakes to Avoid
- -Capitalizing an unusual year's income without stabilizing it
- -Applying a rate extracted on a different income definition
- -Assuming direct capitalization requires level income forever
Concept Deep Dive
Analysis
This question tests the core requirements of direct capitalization. The method converts one year's income expectancy into value, so the income must be representative and the rate must be compatible with that income definition and the expected benefits. The wrong options add requirements or assumptions that the method does not impose.
Background Knowledge
Direct capitalization converts a single year's income expectancy into value by dividing by a rate or multiplying by a factor. Because the rate is extracted from market sales, the subject's income must be measured the same way, and unusual items such as lease-up costs need appropriate separate treatment.
Real-World Application
An appraiser values a retail center whose current year includes an unusual one-time roof repair. The appraiser stabilizes expenses to a representative year and applies a rate extracted from sales analyzed on the same expense basis.
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
An appraiser is verifying the sale of a 12-unit apartment building. The broker will not release dollar income figures but reports that the price was 6.0 times EGI and 5.4 times PGI, and that the buyer's anticipated operating expenses were 55% of EGI. What overall capitalization rate does the sale indicate?
Next Question
Annual PGI for the subject property is $105,000, and combined vacancy and collection loss is $5,250. There is no other income. Annual operating expenses, excluding debt service, total $29,750. Using an 8% overall rate, what is the indicated value?