A commercial property produces net annual income of $120,000. Using a capitalisation rate of 7.5%, what value does the income approach indicate?
Correct Answer
D) $1,600,000
The income approach divides net annual income by the capitalisation rate: $120,000 ÷ 0.075 = $1,600,000. A lower rate would give a higher value and a higher rate a lower value.
Why This Is the Correct Answer
Value = net income ÷ capitalisation rate = $120,000 ÷ 0.075 = $1,600,000.
Why the Other Options Are Wrong
Option A: $1,440,000
$1,440,000 is 12 times the income, a multiplier shortcut, not the income divided by the 7.5% rate.
Option B: $2,000,000
$2,000,000 is $120,000 capitalised at 6%, not at the 7.5% rate in the question.
Option C: $1,750,000
$1,750,000 would need a capitalisation rate of about 6.9%, lower than the 7.5% given.
Deep Analysis of This Valuation Question
Capitalisation converts one year's net income into a capital value using a rate drawn from sales of similar investment properties. Value and rate move in opposite directions: a small change in the rate makes a large change in value, so choosing a well-supported market rate matters as much as getting the income right.
Background Knowledge for Valuation
The income approach is one of the three main valuation approaches, alongside sales comparison and cost. It suits investment property such as shops, offices and industrial buildings. The capitalisation rate (or yield) is analysed from recent sales: sale price divided into net income.
Memory Technique
Remember DIVE: Divide Income by the Valuation Exchange rate (cap rate). Think of diving into a pool - you go DOWN (divide) to find the bottom value. The deeper you dive (lower cap rate), the higher the value you find at the bottom.
When you see income approach questions, immediately think DIVE. Identify the annual net income, identify the cap rate, then divide income by cap rate. The visual of diving down helps remember that you divide (go down) to get the property value.
Exam Tip for Valuation
Always convert percentage cap rates to decimals (7.5% = 0.075) before calculating. Double-check your division: income ÷ cap rate = value. Higher cap rates mean lower values, lower cap rates mean higher values.
Real World Application in Valuation
A commercial real estate agent is helping an investor evaluate a retail building generating $120,000 annual net rent. Comparable properties in the area are selling at 7.5% cap rates. Using the income approach, the agent calculates the property's value at $1,600,000, helping the investor determine if the $1,550,000 asking price represents good value. This valuation supports the agent's professional advice and ensures compliance with REA Act requirements for competent service.
Common Mistakes to Avoid on Valuation Questions
- •Using gross income instead of net operating income
- •Forgetting to convert percentage to decimal (using 7.5 instead of 0.075)
- •Multiplying instead of dividing (income × cap rate instead of income ÷ cap rate)
Related Topics & Key Terms
Key Terms:
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- → What is the primary purpose of Land Value (LV) in New Zealand rating valuations?
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