A commercial property generates annual rental income of $120,000. After deducting operating expenses of $30,000, the net operating income is $90,000. Using a market-derived capitalization rate of 7.5%, what is the indicated value using the income approach?
Correct Answer
A) $1,200,000
Using the income approach formula: Value = Net Operating Income ÷ Capitalization Rate. Therefore: $90,000 ÷ 0.075 = $1,200,000. The net operating income of $90,000 (after deducting expenses) is capitalized at the market rate of 7.5% to determine the property's investment value.
Why This Is the Correct Answer
The income approach capitalises net operating income: $90,000 ÷ 0.075 = $1,200,000.
Why the Other Options Are Wrong
Option B: $1,333,333
$1,333,333 would need a capitalisation rate of 6.75% on the $90,000 net income, not the 7.5% given.
Option C: $1,500,000
$1,500,000 is $90,000 capitalised at 6%, a lower rate than the market rate given.
Option D: $1,600,000
$1,600,000 capitalises the $120,000 gross rent and ignores the $30,000 of operating expenses.
Deep Analysis of This Valuation Question
The usual trap is capitalising gross rent. Operating expenses the owner bears, such as rates, insurance, maintenance and management, reduce the income an investor actually receives, so they come off before capitalising. Using gross rent here would overstate value by $400,000.
Background Knowledge for Valuation
Net operating income is gross income less vacancy allowance and the outgoings the owner pays. A capitalisation rate analysed from sales on a net basis must be applied to net income, and a gross rate to gross income; mixing the two gives a wrong answer.
Memory Technique
Remember 'NOI over CAP equals VALUE' - like a fraction where Net Operating Income sits on top of the Capitalization rate. Think of it as 'NO Income, CAP the value' - without proper NOI calculation, you can't cap-ture the true value.
When you see income approach questions, immediately identify: 1) Calculate NOI (gross income minus expenses), 2) Identify the cap rate, 3) Divide NOI by cap rate. Remember the fraction visual: NOI/CAP = VALUE.
Exam Tip for Valuation
Always calculate NOI first by subtracting operating expenses from gross income. Then divide NOI by the cap rate (as a decimal). Double-check your decimal conversion - 7.5% = 0.075. Work systematically through the formula to avoid calculation errors.
Real World Application in Valuation
A property investor is considering purchasing a small office building generating $120,000 annual rent. After accounting for maintenance, insurance, rates, and management costs totaling $30,000, the NOI is $90,000. Using comparable sales data, the market cap rate is determined to be 7.5%. The investor uses this income approach calculation to determine a fair purchase price of $1,200,000, ensuring the investment meets their required return expectations and aligns with market conditions for similar commercial properties.
Common Mistakes to Avoid on Valuation Questions
- •Using gross income instead of net operating income
- •Converting cap rate incorrectly (using 7.5 instead of 0.075)
- •Forgetting to subtract operating expenses before applying the formula
Related Topics & Key Terms
Key Terms:
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A commercial property produces net annual income of $120,000. Using a capitalisation rate of 7.5%, what value does the income approach indicate?
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