CFA Level II ExamAlternative InvestmentsMedium
A real estate investor is considering a property with an initial cost of $10 million. The property is expected to generate an annual Net Operating Income (NOI) of $800,000. Similar properties in the market are trading at a capitalization rate of 7.5%. Based on this information, what is the indicated market value of the property using the direct capitalization method?
- A$10,000,000
- B$10,666,667
- C$9,375,000
- D$12,000,000
Show answer & explanationAnswer & explanation
Correct answer: B. $10,666,667
The direct capitalization method estimates property value by dividing the Net Operating Income (NOI) by the capitalization rate (Cap Rate). In this case, Value = NOI / Cap Rate = $800,000 / 0.075 = $10,666,666.67.
Why the other options are wrong
- A. This is the initial cost, not the indicated market value based on direct capitalization.
- C. This would imply a higher cap rate ($800,000 / $9,375,000 = 8.53%), not the given 7.5%.
- D. This would imply a lower cap rate ($800,000 / $12,000,000 = 6.67%), not the given 7.5%.
Direct Capitalization Method
A real estate valuation technique that estimates the value of an income-producing property by dividing its Net Operating Income (NOI) by an appropriate capitalization rate (cap rate).
- Value = NOI / Cap Rate.
- Used for stable, seasoned properties.
- Cap rate is derived from comparable sales.
Memory trick: Value is found in income, costs, or comps.