Tennessee Realtor State Practice Exam

What is the capitalization formula used in the income approach?

1. Value = Income x Rate

2. Value = Income + Rate

3. Value = Income / Rate

4. Value = Income - Rate

The correct answer is: Value = Income / Rate

The capitalization formula used in the income approach is centered on the concept of converting income generated by a property into its value. In this context, the correct formula states that the value of an income-producing property is determined by dividing the annual net operating income (NOI) by the capitalization rate (expressed as a decimal). This means that the value of the property is a function of the income it generates and the perceived risk associated with that income, represented by the capitalization rate. When applying this formula, if the property generates a steady and reliable income, and the capitalization rate is appropriately chosen based on market conditions and comparable properties, the resulting value depicts what an investor might pay for that income stream. This approach is particularly effective for properties like rental real estate, commercial buildings, or any asset where income is a pivotal factor in determining its market value. Using addition or subtraction in the formula would not accurately reflect the relationship between income and value; thus, those alternatives do not pertain to the fundamental income capitalization method.