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In the income capitalization approach, how is NOI calculated?

  1. By averaging all income sources from the property.

  2. By subtracting total operating expenses from effective gross income.

  3. By adding all expenses to gross rental income.

  4. By estimating the market value minus property taxes.

The correct answer is: By subtracting total operating expenses from effective gross income.

In the income capitalization approach, Net Operating Income (NOI) is calculated by taking the effective gross income and subtracting total operating expenses. This method reflects the operational performance of the property, as NOI represents the income generated from the property after all costs associated with managing and maintaining that property are accounted for. Effective gross income includes all income generated from the property, such as rental income and other sources, but it contrasts with gross income because it also accounts for potential vacancies and credit loss. By deducting total operating expenses—such as property management fees, maintenance costs, property taxes, and insurance—the calculation effectively shows the profit that can be expected from the property before financing and tax considerations. The other options do not accurately represent how NOI is calculated in this context. Averaging all income sources does not consider the operational expenses involved, adding all expenses to gross rental income would incorrectly inflate the figure being assessed, and estimating market value minus property taxes deviates from the standard principles of the income capitalization approach in determining the profitability of the property itself.