CFA Level IAlternative InvestmentsEasy
A commercial office property generates potential gross rental income of $2,000,000 per year. The vacancy and collection loss rate is 5%, and annual operating expenses (excluding debt service and capital expenditures) are $600,000. If comparable properties trade at a 6.5% capitalization rate, what is the estimated value of the property using the income approach?
- A$18,461,538
- B$21,538,462
- C$15,384,615
- D$20,000,000
Show answer & explanationAnswer & explanation
Correct answer: D. $20,000,000
Effective gross income = $2,000,000 × (1 − 0.05) = $1,900,000. Net operating income (NOI) = $1,900,000 − $600,000 = $1,300,000. Value = NOI / Cap Rate = $1,300,000 / 0.065 = $20,000,000.
Why the other options are wrong
- A. Applies vacancy loss twice or uses an incorrect expense figure.
- B. Uses gross income minus expenses but forgets to apply the vacancy adjustment.
- C. Incorrectly divides gross income (not NOI) by the cap rate.
Net Operating Income (NOI) & Cap Rate Valuation
NOI is gross income adjusted for vacancy losses minus operating expenses (excluding financing costs and capex). Property value = NOI ÷ Capitalization rate.
- NOI excludes debt service and capital expenditures
- Cap rate reflects market required return for similar properties
- Lower cap rates imply higher property values for a given NOI
Memory trick: Gross income shrinks by vacancy and expenses before it becomes NOI.