A commercial property generates $120,000 in annual gross rental income and has operating expenses of $35,000. If the property sells for $850,000, what is the CAP rate?
Correct Answer
A) 10.0%
First calculate NOI: $120,000 - $35,000 = $85,000. Then divide NOI by property value: $85,000 ÷ $850,000 = 0.10 or 10.0%. The CAP rate formula is NOI divided by property value or purchase price.
Why This Is the Correct Answer
Option A (10.0%) is correct because it properly applies the CAP rate formula. First, calculate NOI: $120,000 gross income minus $35,000 operating expenses equals $85,000. Then divide NOI by property value: $85,000 ÷ $850,000 = 0.10 or 10.0%. This follows standard commercial real estate valuation principles recognized across Canadian jurisdictions and is essential knowledge for licensees dealing with commercial investment properties under provincial real estate legislation.
Why the Other Options Are Wrong
Option B: 14.1%
Option B (14.1%) incorrectly uses gross rental income instead of NOI in the calculation. This would be $120,000 ÷ $850,000 = 0.141 or 14.1%. However, CAP rate must always use Net Operating Income, not gross income, as it represents the actual return after operating expenses. Using gross income inflates the rate and provides misleading investment analysis.
Option C: 4.1%
Option C (4.1%) appears to incorrectly use operating expenses in the numerator instead of NOI. This would be $35,000 ÷ $850,000 = 0.041 or 4.1%. This fundamental error misrepresents the property's income-generating capacity and would severely understate the investment return, leading to poor investment decisions.
Option D: 12.5%
Option D (12.5%) likely results from calculation errors or using incorrect figures in the formula. There's no logical mathematical path using the given numbers ($120,000 income, $35,000 expenses, $850,000 value) that would yield 12.5%. This demonstrates the importance of careful calculation and proper formula application in commercial property analysis.
Deep Analysis of This Commercial Real Estate Question
The capitalization rate (CAP rate) is a fundamental metric in commercial real estate valuation that measures the relationship between a property's net operating income and its market value. This question tests understanding of the CAP rate formula: NOI ÷ Property Value = CAP Rate. The calculation requires first determining the Net Operating Income by subtracting operating expenses from gross rental income ($120,000 - $35,000 = $85,000), then dividing by the sale price ($85,000 ÷ $850,000 = 0.10 or 10%). CAP rates are crucial for investors to compare properties, assess risk, and determine fair market value. In Canadian commercial real estate, understanding CAP rates is essential for licensees advising clients on investment properties, as required under provincial regulations like TRESA in Ontario and RESA in Alberta.
Background Knowledge for Commercial Real Estate
The capitalization rate (CAP rate) is calculated as Net Operating Income divided by property value or purchase price. NOI is gross rental income minus operating expenses (but not debt service or depreciation). CAP rates help investors compare properties and assess risk - higher CAP rates generally indicate higher risk/return properties. In Canada, real estate licensees must understand these calculations when advising clients on commercial investments, as required under provincial legislation like TRESA, RESA, and RECSA. CAP rates vary by property type, location, and market conditions.
Memory Technique
The CAP Formula TriangleVisualize a triangle with 'CAP' at the top and 'NOI' and 'Value' at the bottom corners. To find CAP rate, cover the top and divide the bottom two (NOI ÷ Value). Remember 'NOI before you GO' - always calculate Net Operating Income first by subtracting operating expenses from gross income.
When you see a CAP rate question, immediately draw the triangle mentally. First calculate NOI (gross income minus operating expenses), then divide by property value. The triangle helps you remember the relationship between all three variables.
Exam Tip for Commercial Real Estate
Always calculate NOI first: gross income minus operating expenses. Then divide NOI by property value. Double-check your decimal placement - CAP rates are typically expressed as percentages between 4-15% for most commercial properties.
Real World Application in Commercial Real Estate
A commercial real estate licensee is helping an investor client evaluate a small office building. The building generates $180,000 annually in rent with $45,000 in operating expenses, listed at $1.35 million. The licensee calculates the CAP rate: NOI of $135,000 ÷ $1.35M = 10%. This helps the client compare it to similar properties and assess if the asking price reflects market value for the income stream.
Common Mistakes to Avoid on Commercial Real Estate Questions
- •Using gross income instead of NOI
- •Forgetting to subtract operating expenses
- •Mixing up the formula (dividing value by NOI)
Key Terms
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A commercial property generates $180,000 in annual rental income and has operating expenses of $45,000. If the capitalization rate is 8%, what is the estimated property value?
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A commercial building is being analyzed for purchase with the following data: Annual rental income $240,000, vacancy rate 8%, operating expenses $45,000, debt service $85,000. What is the property's Net Operating Income (NOI)?
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A commercial property generates $120,000 in annual rental income and has operating expenses of $35,000. If the capitalization rate is 8%, what is the estimated property value?