Question

Shanta, a property manager of a retail center, is using the Income Capitalization Approach in trying to project future earnings for the partners who own the center. She first estimates the annual potential gross income, subtracts an appropriate allowance for vacancy and collection losses to arrive at a gross income, deducts operating expenses (including debt service and mortgage payments). This gives her the Net Operating Income. She then applies a capitalization rate to the net income to determine the value. Did she use the correct steps?A. Yes, Shanta went through all four steps correctly, debt service and mortgage payments may be included.

B. No, when Shanta was deducting operating expenses, she included debt service and mortgage payments when they shouldn't have been included.
C. No, Shanta should have added an appropriate allowance for vacancy and collection losses instead of subtracting these items.
D. None of the Above.

Answer 1

B. No, when Shanta was deducting operating expenses, she included debt service and mortgage payments when they shouldn't have been included

Step-by-step explanation:

Under income capitalization approach of property valuation, firstly, future gross income from the property is estimated.

Secondly, from above, an allowance for vacancy and bad debts losses is deducted to arrive at Gross Income.

From the gross income, operating expenses i.e routine business operation expenses are deducted. Herein, it is noteworthy that interest payable on loan availed would be deducted but the principal repayment is not operating expense and thus cannot be deducted.

Deduction of such operating expenses reveals net annual operating income from such property.

Applying a capitalization rate i.e dividing this annual net operating income by capitalization rate reveals the value of the property.

In the given case, Shanta deducted debt services and mortgage payments. Those were not to be deducted as those do not represent operating expenses.