An appraiser calculates NOI after a replacement allowance and before financing. Which item is not deducted in arriving at NOI?
Correct Answer
C) Mortgage principal and interest.
With NOI defined after a replacement allowance and before financing, mortgage debt service is excluded while the stated reserve is included. Some analyses place reserves below NOI, so the treatment of reserves must be stated rather than assumed to be a universal rule.
Why This Is the Correct Answer
Option C is correct because mortgage principal and interest payments are debt service, which is a financing cost, and NOI is defined here as before financing. Debt payments reflect the return on and return of the mortgage interest, not the cost of operating the property. They are deducted below NOI to reach cash flow to equity.
Why the Other Options Are Wrong
Option A: The building insurance premium.
Option A, the building insurance premium, is a routine operating expense. It is deducted in reaching NOI under this definition of NOI.
Option B: Management operating costs.
Option B, management operating costs, is a normal operating expense of the property. It is included in expenses deducted before NOI.
Option D: The annual replacement allowance.
Option D, the annual replacement allowance, is included because NOI is defined here as after a replacement allowance. The reserve is deducted before NOI here.
NOI ignores the lender
NOI is what the property earns; the mortgage payment is what the owner pays the lender afterward.
How to use: Use this to exclude debt service whenever a question asks what is in operating expenses or NOI.
Exam Tip
Read how NOI treats reserves, but treat debt service as below NOI when NOI is defined before financing.
Common Mistakes to Avoid
- -Deducting mortgage payments as an operating expense
- -Omitting a replacement allowance that the stated definition of NOI includes
- -Assuming reserves are treated the same way in every analysis
Concept Deep Dive
Analysis
This question tests which items fall inside NOI under a stated definition. NOI here is after a replacement allowance and before financing, so operating costs and the reserve are deducted, while debt service is not. The key is recognizing that financing payments are not property operating expenses.
Background Knowledge
NOI measures the income a property produces from operations, independent of how it is financed. Debt service is subtracted from NOI to find before-tax cash flow to equity, and the treatment of replacement reserves depends on how NOI is defined.
Real-World Application
An investor gives an appraiser an operating statement that lists the mortgage payment among expenses. The appraiser removes the principal and interest so that NOI reflects property operations only.
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?
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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?
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Annual potential rental income is $600,000 and vacancy loss alone is $36,000. What percentage of potential rent does that loss represent?
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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?