An analyst is evaluating an investment in an apartment complex based on the following annual data:
| Gross potential rental income | $2,100,000 |
| Estimated vacancy and collection expenses | 3% |
| Operating expenses | $1,600,000 |
| Depreciation | 300,000 |
| Current mortgage rate | 5% |
| Financing percentage | 80% |
| Market capitalization rate | 12% |
| Cost of equity | 15% |
Based on the income approach, the value of the investment is closest to:
B is correct because using the income approach,
($2,100,000 – .03 × $2,100,000 – $1,600,000)/0.12 = $437,000/0.12 = $3,641,667.
The property is appraised based on cash flows and is independent of the financing decision.
Thus, the market capitalization rate is used rather than the lending rate. Depreciation is also not deducted because it is implicitly assumed that repairs and maintenance allow the investor to keep the building in good condition.