Illinois exam glossary
Income approach to value
Two buildings can collect the same rent and have very different operating costs. The income approach asks what future benefits the property can produce, then converts those benefits into a value indication. The arithmetic matters, but so does choosing consistent income, expenses and rates.
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The short answer
The income approach estimates value from expected property income and other future benefits. Direct capitalization commonly uses annual net operating income divided by an overall capitalization rate: V = I / R. A gross rent multiplier uses gross rent instead of NOI. Discounted cash flow values separately timed future cash flows and resale proceeds. Each method needs market-supported, consistent inputs.
Reviewed October 25, 2026. PSI lists income analysis at National III.B.4 within the eight-question Valuation domain; income-and-value math also appears in Calculations. Neither is a question quota for this page. The worked numbers are fictional teaching cases, not market rates, appraisals or investment recommendations. Fannie Mae examples are program policy, with the September 2026 UAD 3.6 supplement identified separately.
Build the income before applying the formula
- Identify what is being valued. The property interest, effective date, leases and purpose of the analysis affect the relevant income. Contract rent is evidence, but it is not automatically market rent or the right income for every interest. An asking rent alone does not establish what tenants will actually pay.
- Define the top line. Potential gross income may include rent and other income already. If a problem instead gives rental-only potential income, add separately stated other income once. Apply vacancy, collection loss and concessions to the basis actually specified; do not silently apply a rent allowance to every revenue source.
- Reach the defined net income. Subtract supported operating expenses from effective income. Property taxes, insurance, management and ordinary maintenance differ from mortgage debt service, owner income taxes and accounting depreciation. Identify the treatment of replacement reserves and capital costs before using the resulting figure.
- Match the income to its rate. Reserve treatment is not identical in every model. OCC commercial guidance includes an imputed replacement reserve in its NOI definition; Fannie Mae's multifamily glossary defines net cash flow as NOI less the full underwritten replacement reserve. Read the convention and use the same basis for the subject and comparable rates.
- Choose the method. For direct capitalization, divide a supported annual net-income measure by a consistent market-derived rate. For a gross multiplier, use the same rent definition and period as the multiplier. For DCF, discount each dated projected cash flow and the net resale proceeds at the appropriate yield rate.
- Check the result and the assumptions. Convert 8% to 0.08, label annual and monthly figures, and state the rounding instruction. Holding positive NOI fixed, a larger positive cap rate gives a smaller value indication. A correct calculation does not validate unsupported rent, vacancy, expenses, growth or comparable data.
- Keep valuation separate from underwriting. Borrower qualifying income can use program-specific documentation and adjustments, including financing costs, that are not an appraisal NOI formula. Likewise, a Fannie Mae approach or rental-comparable requirement is not a universal Illinois statute.
| Task | Relationship | Key check |
|---|---|---|
| Effective income, with rental-only potential income | Rental potential - specified rent losses + separate other income | Add other revenue once |
| Defined net operating income | Effective income - selected operating deductions | Read the reserve and capital-cost convention |
| Direct-cap value | V = I / R | Annual net income and rate on the same basis |
| Income implied by value and rate | I = V x R | Use the rate as a decimal |
| Extracted cap rate | R = I / V | Use a consistent comparable income and price |
| Gross multiplier value | Gross rent x matching GRM | Monthly with monthly; annual with annual |
| Present value of a dated cash flow | CF at time t / (1 + discount rate)^t | Include net resale at the correct time |
| Fannie Mae UAD 3.6 rental support | Minimum three rental comparables for each subject unit | A rental unit is not necessarily a separate building |
The distinctions that matter
| Distinction | How it works | What to notice |
|---|---|---|
| Income approach and anticipation | The principle of anticipation links value to expected future benefits. Historical performance helps estimate them; it is not the value conclusion by itself. | Expected benefits, not only last year's rent. |
| Potential and effective gross income | Potential income precedes the specified vacancy and collection adjustments. Effective income reflects those adjustments and appropriate other revenue. | Was other income included in the first figure already? |
| Effective gross income and NOI | The selected operating expenses reduce effective income to a defined net measure. Read the reserve convention before deciding what the label includes. | Which costs have already been deducted? |
| Property NOI and financed-owner cash flow | Property-level NOI excludes mortgage debt service. A financed owner's cash flow may deduct it and other items below NOI. | The property and the owner's financing are separate. |
| Routine expenses and capital needs | An ordinary repair expense differs from a major replacement. A model may use an annual reserve or separately forecast capital costs. | Do not count the same burden twice. |
| Cap rate and discount rate | A cap rate converts a selected one-year income measure to value. A discount rate brings separately timed future benefits to present value. | One income-to-value ratio versus dated cash-flow discounting. |
| Cap rate and gross rent multiplier | A cap rate relates net income to value. A GRM relates gross rent to price and does not explicitly model each operating expense. | Net-income division versus gross-rent multiplication. |
| Contract rent and market rent | The lease sets contract rent. Market rent reflects supported competitive terms for the relevant interest and date. | Account for lease terms, concessions and expense obligations. |
| A vacancy snapshot and stabilized operation | Full occupancy today does not prove that typical future vacancy or collection loss is zero. The selected allowance needs support. | No automatic universal 5% or 25% assumption. |
| A valuation indication and loan qualifying income | Collateral value and borrower repayment capacity serve different purposes and use different program rules. | Do not turn a lender's rent haircut into universal appraisal NOI. |
Work through the facts
Build a defined after-reserve net income
Rental-only potential income is $300,000 annually. Rent vacancy and collection loss is $24,000. Other income is $12,000 with no further loss adjustment in this case. Operating expenses are $96,000. The specified model also deducts a $12,000 annual replacement allowance before capitalization.
- $300,000 - $24,000 + $12,000 = $288,000 effective income.
- $288,000 - $96,000 - $12,000 = $180,000 after-reserve net income.
- The cap rate must use that same after-reserve basis; no mortgage payment is included.
Answer: Effective income is $288,000, and the model's selected annual net income is $180,000.
Capitalize annual net income
Supported annual NOI is $156,000 on the specified basis. Comparable evidence supports an 8% overall cap rate using that same basis.
- 8% = 0.08.
- $156,000 / 0.08 = $1,950,000.
Answer: The direct-cap indication is $1,950,000.
Extract a comparable rate
A comparable sells for $2,400,000 with supported annual NOI of $168,000 on the selected convention.
- R = I / V.
- $168,000 / $2,400,000 = 0.07 = 7%.
Answer: The extracted rate is 7%; decide separately whether that comparable supports the subject's rate.
Hold income constant
Use $120,000 annual NOI to compare hypothetical 6% and 8% cap rates, with every other input fixed.
- $120,000 / 0.06 = $2,000,000.
- $120,000 / 0.08 = $1,500,000.
- The exercise isolates the rate; it is not a forecast that a real market changes only one factor.
Answer: The higher cap rate produces the lower value indication for the same positive NOI.
Use a monthly multiplier
Supported gross monthly market rent is $2,600. Comparable evidence supports a monthly GRM of 145 using the same gross-rent definition.
- $2,600 x 145 = $377,000.
- Multiplying annual rent by that monthly multiplier would introduce a twelvefold period error.
Answer: The GRM indication is $377,000, subject to the comparability and income assumptions.
Keep financing below NOI
A property has $140,000 annual NOI. One buyer has no debt service. Another would pay $90,000 annually in debt service. Assume no other below-NOI cash items for this illustration.
- The property-level NOI is $140,000 for either financing choice.
- $140,000 - $90,000 = $50,000 after-debt cash flow for the financed example.
Answer: Do not substitute $50,000 for property NOI when using a property-level cap rate.
A full building still has a future
A building is fully occupied today. Supported market evidence and expected normal turnover indicate a 5% stabilized rent-loss allowance for the modeled year.
- A current occupancy snapshot is not a guarantee of future collections.
- The 5% is an assumption supported by this fictional case, not a statewide or Fannie Mae appraisal rule.
Answer: Use the supported assumption for the model rather than assume permanent zero loss.
Other income was included already
The problem defines total potential income as $312,000, including $12,000 other revenue. It specifies $24,000 total income loss and $96,000 operating expenses, before any reserve deduction.
- $312,000 - $24,000 = $288,000 effective income.
- $288,000 - $96,000 = $192,000 before-reserve net income.
- Adding the $12,000 again would count the same revenue twice.
Answer: Read the definition: the $12,000 is already in the top line.
The reserve convention changes the numerator
Effective income is $288,000, selected operating costs excluding reserves are $96,000, and the replacement allowance is $12,000. Two comparable-rate sets use different reserve conventions.
- Before the reserve, net income is $192,000; after it, $180,000.
- At a hypothetical 8% rate, $192,000 / 0.08 = $2,400,000 while $180,000 / 0.08 = $2,250,000.
- That difference shows why the same numerical rate cannot simply be reused across mismatched conventions.
Answer: Use the income measure consistent with the rate evidence; the labels alone are insufficient.
Discount separately timed benefits
A fictional unleveraged DCF has $18,000 cash flow at the end of year 1 and $19,000 at the end of year 2. Net resale proceeds after selling costs are $220,000 at the end of year 2. Use a 10% annual discount rate.
- Year 2 combines $19,000 + $220,000 = $239,000.
- Present value = $18,000 / 1.10 + $239,000 / 1.10^2.
- The sum is $213,884.30 rounded to cents.
Answer: The illustrative present value is $213,884.30; different timing or assumptions would change it.
Mistakes to avoid
- Capitalizing gross rent as though it were NOI. Identify the required income measure before applying the rate.
- Adding other income twice. Check whether the potential-income total already includes it.
- Treating every reserve convention as identical. Match the numerator and comparable rate on the same treatment.
- Deducting the mortgage to calculate property NOI. Financing affects owner cash flow below property-level NOI.
- Mixing annual rent with a monthly GRM. Match the period and gross-income definition.
- Using 8 instead of 0.08. Convert a percentage to its decimal rate before dividing.
- Treating a cap rate as the total investment return. A one-year ratio does not separately show every future benefit, cost and timing.
- Calling a Fannie Mae requirement universal Illinois law. Identify the program, reporting framework and dated source.
Check your understanding
These are original teaching questions, not recalled or predicted PSI questions. Answer first, then explain why the other choices fail.
1. Which principle connects the income approach to expected future benefits?
- Plottage
- Anticipation
- A rule that historical cost always equals value
- Regression alone
Show answer and explanation
Answer: B. Anticipation
The income approach evaluates expected benefits. Historical evidence can help support the forecast but does not, by itself, fix the present value.
2. Annual NOI is $90,000 and the supported cap rate is 7.5% on the same basis. What is the direct-cap indication?
- $675,000
- $1,200,000
- $12,000,000
- $120,000
Show answer and explanation
Answer: B. $1,200,000
$90,000 / 0.075 = $1,200,000. Convert the percentage to a decimal and use consistent annual net income and rate definitions.
3. Rental-only potential income is $200,000, specified rent loss is $10,000 and separate other income is $5,000 with no additional loss in this case. What is effective income?
- $185,000
- $205,000
- $195,000
- $215,000
Show answer and explanation
Answer: C. $195,000
$200,000 - $10,000 + $5,000 = $195,000. The problem explicitly separates other income so it is added once.
4. Which item is excluded from ordinary property-level NOI?
- Mortgage debt service
- Routine property maintenance
- Property insurance
- Property taxes
Show answer and explanation
Answer: A. Mortgage debt service
Property NOI measures operation before the owner's financing. Debt service belongs below that measure; operating costs must still be defined consistently.
5. A comparable sells for $1,500,000 with supported annual NOI of $105,000. What is its extracted cap rate?
- 10.5%
- 7%
- 14.29%
- 70%
Show answer and explanation
Answer: B. 7%
$105,000 / $1,500,000 = 0.07 = 7%. This establishes the arithmetic ratio; whether the comparable supports the subject's rate needs separate judgment.
6. A problem gives gross monthly rent of $2,600 and a matching monthly GRM of 145. What is the indication?
- $31,200
- $377,000
- $179.31
- $4,524,000
Show answer and explanation
Answer: B. $377,000
$2,600 x 145 = $377,000. Multiplying annual rent by the monthly multiplier instead would create a twelvefold period mismatch.
7. Positive annual NOI stays fixed while the positive cap rate rises. What happens to V = I / R?
- Value necessarily rises
- The calculated value falls
- NOI automatically becomes gross income
- The rate has no effect
Show answer and explanation
Answer: B. The calculated value falls
With a positive fixed numerator, dividing by a larger positive denominator produces a smaller value. This isolates the formula; it does not promise that a real market changes only the rate.
8. Total potential income is $312,000 and already includes $12,000 other income. Total specified losses are $24,000. What is effective income?
- $276,000
- $288,000
- $324,000
- $300,000
Show answer and explanation
Answer: B. $288,000
$312,000 - $24,000 = $288,000. The separately described $12,000 is already included, so adding it again would double count it.
9. Two cap-rate data sets use different replacement-reserve treatments. Which step is sound?
- Replace NOI with mortgage payments
- Deduct the same reserve twice to be safe
- Use the same numerical rate without reading the definitions
- Make the subject and comparable income measures consistent before using the rate
Show answer and explanation
Answer: D. Make the subject and comparable income measures consistent before using the rate
The numerator and its rate must reflect the same convention. OCC and Fannie Mae sources illustrate that similarly named net measures can place reserves differently.
10. Under the September 2026 UAD 3.6 SB4-1.3-10 income policy, what rental support is specified when the income approach is used?
- Exactly three separate buildings in every assignment
- No rental data if the arithmetic is correct
- At least three rental comparables for each subject unit, with permitted comparable-unit reuse
- One rental listing for the entire property in every case
Show answer and explanation
Answer: C. At least three rental comparables for each subject unit, with permitted comparable-unit reuse
The supplement requires at least three rental comparables for each subject unit. A comparable represents a unit, not necessarily an entire property, and the same comparable unit can be used for more than one subject unit if applicable. This is Fannie Mae program policy.
11. A property produces $140,000 NOI and the financed owner pays $90,000 debt service. With no other below-NOI cash items in this illustration, which statement is correct?
- NOI is $50,000 for every buyer
- NOI is $230,000
- $140,000 remains property NOI; the after-debt cash flow is $50,000
- A cash buyer has no NOI
Show answer and explanation
Answer: C. $140,000 remains property NOI; the after-debt cash flow is $50,000
$140,000 - $90,000 = $50,000 after debt service. The financing choice does not replace the property-level NOI with owner cash flow.
12. A fictional DCF receives $18,000 at year 1 end and $19,000 plus $220,000 net resale at year 2 end. At 10% annually, what is present value rounded to cents?
- $235,454.55
- $257,000.00
- $197,520.66
- $213,884.30
Show answer and explanation
Answer: D. $213,884.30
$18,000 / 1.10 + ($19,000 + $220,000) / 1.10^2 = $213,884.30 rounded to cents. The resale is net of selling costs and arrives at the end of year 2, so it is combined with that year's cash flow and discounted twice.
Common questions
What is the income approach?
It develops a value indication from expected income and other property benefits. Direct capitalization, a gross income multiplier and discounted cash flow use different relationships. The relevant interest, income definition, period and market evidence matter; a formula does not make unsupported inputs reliable.
Why is anticipation associated with the income approach?
Anticipation connects value to future benefits. Past rents, expenses and sales can help estimate those benefits, but the analysis looks forward from the relevant date. The forecast must account for the selected rights, risk and market evidence instead of assuming last year repeats forever.
What are the three direct-capitalization formulas?
V = I / R, I = V x R and R = I / V. In this lesson, I is the selected annual net-income measure and R is its consistent overall rate expressed as a decimal. Use a positive supported rate and keep the same expense and reserve convention across the comparison.
How do potential and effective gross income differ?
Potential income precedes the modeled vacancy and collection adjustments. Effective income reflects those adjustments and appropriate other income. Check whether the potential total already includes that other income. A rental-only top line and an all-sources top line cannot both receive the same extra revenue a second time.
What operating expenses are deducted for NOI?
Typical property operation includes supported taxes, insurance, management, utilities and ordinary maintenance. Define the actual model and normalize unusual or omitted costs. Debt service, owner income tax and accounting depreciation are different from property operating expenses. Replacement reserves and capital needs require the convention described separately below.
Are replacement reserves always above or below NOI?
There is no safe universal label. OCC commercial guidance includes an imputed replacement allowance in its NOI definition. Fannie Mae's multifamily glossary defines net cash flow as NOI minus the full underwritten replacement reserve. Read the source and assignment, then keep the subject numerator and comparable rate on the same basis. A reserve's funding status is not necessarily the modeled expense.
Is a roof replacement the same as routine maintenance?
Not automatically. A major replacement is a capital need, while ordinary maintenance supports ongoing operation. A model can account for capital needs through specified reserves or explicitly forecast expenditures. Do not charge the same burden twice or assume a major cash outlay is a recurring annual operating cost merely because it appears on an owner's statement.
Why does mortgage debt service stay out of property NOI?
Financing depends on the owner's capital structure. Property-level NOI permits analysis before those financing payments. Cash flow to an owner can then deduct debt service and other applicable below-NOI items. A property-level cap rate should not be paired casually with that financed-owner cash-flow numerator.
Are property taxes and owner income taxes the same expense?
No. Real estate taxes are generally a property operating expense in this model. The owner's income tax is not. Accounting or tax depreciation also differs from a cash operating expense. This distinction explains the exam model; it is not an individual tax-return calculation or advice about deductions.
How is a cap rate derived from a comparable?
Divide supported annual NOI by its sale price or selected value basis: R = I / V. Then assess comparability of the interest, date, location, condition, leases, income quality, expenses and risk. A mathematically correct ratio from an unsuitable sale is not automatically a supported rate for the subject.
Why does a higher cap rate reduce value?
For the same positive income, V = I / R gets smaller when the positive denominator increases. Actual market income, risk and growth can change together, so this is a comparison holding other factors fixed. It is not a recommendation to buy whichever property advertises the highest cap rate.
Is a cap rate the investor's total return?
No. It relates a selected one-year net-income measure to value. By itself it does not separately capture every growth assumption, resale amount, financing effect, tax consequence or capital need. An overall rate and a discount rate are different tools, even when a particular model produces similar numerical rates.
How does GRM differ from a cap rate?
GRM multiplies gross rent by a supported price-to-rent multiplier. A cap rate divides a net-income measure by value or divides that income by the rate to indicate value. Gross multipliers do not explicitly model each vacancy and expense deduction, so compare properties and rent definitions carefully.
Can I use annual rent with a monthly GRM?
No. Match the period used to derive the multiplier. In the example, $2,600 monthly rent times a monthly GRM of 145 gives $377,000. Annualizing that rent and using the unchanged monthly multiplier would inflate the result twelvefold. Label both inputs before calculating.
What does discounted cash flow add?
DCF assigns expected cash flows to particular dates and discounts them to present value at the selected yield rate. A property model can include rent changes, expenses, capital costs, lease rollover and net resale proceeds. Timing, terminal assumptions and income definitions matter; the worked example is fictional and does not determine a market discount rate.
Must actual rent always be used?
No. Contract rent and market rent answer different questions. Review the interest being valued, lease term, concessions, renewals, expense responsibility and supported competing rentals. A below-market lease can matter to the relevant interest; do not replace it with market rent automatically without considering what rights are being valued.
Does full occupancy mean zero stabilized vacancy?
No. Current occupancy is evidence, not a guarantee of perpetual occupancy or collection. The selected allowance should be supported by the property and market analysis. Do not import a fictional 5% allowance, a lender's 75% rent calculation or another property's history as a universal appraisal rule.
What does Fannie Mae require for the income approach?
Fannie Mae's standard B4-1.3-10 and the identified September 2026 UAD 3.6 supplement require it for two- to four-unit valuation and describe its potential use in substantial single-family rental markets. Sole reliance on the income approach is not acceptable. The UAD 3.6 policy additionally specifies at least three rental comparables for each subject unit. A comparable represents a unit, not necessarily a whole property, and may serve more than one subject unit when applicable. These are program requirements, not universal Illinois statutes.
Is borrower qualifying rental income the same as appraisal NOI?
No. The September 2026 Fannie Mae subject-property rental-income guidance uses documentation, experience, transaction and financing conditions to calculate qualifying income. Its 75% gross-rent step in specified cases is not a universal appraisal vacancy or operating-expense formula. Review the relevant program path instead of substituting one purpose's number for another.
How should I review an income-approach practice answer?
Label the interest and date, the rent period, what the top line includes, the selected deductions and the rate convention. Write the equation before calculating and follow the stated rounding. Then explain why a wrong choice confuses gross and net income, periods or reserve treatment. A score on these original questions is not a validated forecast of exam readiness.
Keep practising
Your next practice step
Put valuation into practice
Choose the approach or value principle that fits the facts, then check your reasoning.
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Official sources and scope
Checked October 25,2026. The identified September 2026 Fannie Mae supplement and rental-income topic are distinct from the older standard appraisal topic. The California chapter supplies teaching methods; OCC and Fannie Mae illustrate different reserve conventions. All worked figures are original hypothetical calculations. A mathematically correct result does not establish the reliability of the market inputs.
- PSI June 24, 2026: national III.B.4 income approach and XI.B.2 capitalization
- California DRE Reference Book chapter 15: overall-rate and income arithmetic
- OCC Commercial Real Estate Lending handbook: income and value analysis
- Fannie Mae B 4-1.3-10: separate income-approach lender context
- Fannie Mae multifamily: defined NCF subtracts replacement reserve from NOI
- Fannie Mae UAD 3.6 supplement: September 2026 income policy
- Fannie Mae September 2026: rental income from the subject property
This is exam preparation, not advice for a specific transaction. State law and the applicable facts control. Our editorial and corrections process explains how to report an issue.