California Real Estate Practice Exam

What type of income is used in the income capitalization approach?

1. Net income

2. Operational gross income

3. Potential gross income

4. Actual earned income

The correct answer is: Potential gross income

In the income capitalization approach, potential gross income is utilized because it represents the total income a property could generate if it is fully leased at market rates, ignoring any vacancies or collection losses. This figure serves as a starting point for analyzing a property's income-generating capabilities before accounting for expenses, vacancies, and other factors that may affect actual revenue. Using potential gross income is critical because it allows investors to assess the maximum income potential, which is foundational for calculating the property’s value. From this starting point, adjustments can be made for effective gross income and net operating income, reflecting the realities of operating expenses and tenant turnover. Other income types listed, such as net income, operational gross income, and actual earned income, do not provide the comprehensive, hypothetical assessment that potential gross income offers, as they typically factor in various deductions or may not represent the property's maximum earning potential. Thus, potential gross income is the most relevant figure in this valuation method.