Cap Rate or GRM: Which Best Estimates Rental Property Value?
Cap rate and GRM (gross rent multiplier) are popular real estate investing measures regularly used by real estate agents and individual investors seeking to determine whether a rental property is, or is not, priced correctly and maybe might be a good investment opportunity.
Both measures only provide an estimate of rental property value, and alone neither provide a true picture of a property's profitability. But they can provide a quick first-glance look at a property's ability to pay its own way and because they are easy to compute, they are a popular way to determine whether a property is in line with similar, other recently sold or listed rental properties.
As a result, cap rate and GRM are used by sellers to set a selling price for rental properties, and by buyers trying to determine what price to offer.
So which is better? At the end of the day, which method better estimates a rental property's value, best measures the property's financial performance, and most helps in an investment decision?
In this article, we'll consider both, and then decide.
Capitalization Rate
Cap rate measures the relationship between a property's net operating income and its price by expressing the percentage rate a property's net operating income is to its value (or sale price), and as is a rule of thumb, whether a property has the ability to pay its own way.
Here's the idea. Net operating income (NOI) is all income after operating expenses thereby representing the amount of money generated by the property that is available to pay the mortgage (the reason lenders look closely at it when making a loan). In this case, cap rate reveals what percent of sale price these available funds are.
The formula is straightforward. To estimate a rental property's value, multiply the property's NOI by whatever capitalization rate you deem appropriate. For example, if similar properties are selling at a 6.0% cap rate and you deem that suitable, multiply the subject property's net operating income by 6.0 to arrive at its market value.
The disadvantage of this method is that it's sometimes difficult to confirm a sold property's actual operating expenses and therefore difficult to determine the actual (not merely the published) rate it sold for.
There is no such thing as a universal cap rate. It depends on individual market areas, what might make one rental income property look like a steal in one city or state at 6%, might not get a second look in another.
Gross Rent Multiplier
The GRM method (expressed as a number) measures the ratio between a rental property's gross scheduled income (GSI) and its price.
Its advantage is that it is very easy to calculate. You don't even need a computer to compute it because you can probably do it in your head. Divide a property's selling price by its GSI to arrive at a gross rent multiplier, and multiply a property's GSI by whatever GRM you deem appropriate to arrive at an estimate of the property's value.
For example, if similar income properties have recently sold at around a 5.0 GRM and your intention is to arrive at an estimated market value for a property generating a gross scheduled income of $80,000, you would multiply that amount by 5.0 to determine its value.
The disadvantage of this method is that it ignores occupancy levels and operating expenses, both of which are important indicators regarding the overall performance of a rental property and required for sound real estate investing decision-making.
As with cap rates, there is no universally correct number for GRM because it is market-driven. It would surprise me, however, to see a number lower than 4.0 or higher than 12.0 and if so, strongly recommend that you dig deeper into the numbers that produced those results. Okay, so which method is the best way to determine a rental property's value?
Though gross rent multiplier is certainly the easier method to calculate, and can serve as a useful precursor to a serious property analysis, most analysts would agree that the more reliable way to determine rental property value is with the cap rate method.
Naturally, you should never rely on capitalization rate alone to provide a true picture of a property's profitability or make a real estate investment decision without correctly computing all the numbers, rates of return, and cash flow scenarios for yourself.
Remember, numbers can be manipulated. When told how great a buy an income property is based upon its cap rate, be sure to reconstruct your own raw data to insure that all is revealed and nothing is concealed before you actively pursue the real estate investment further.
About the Author
James Kobzeff is the developer of ProAPOD - leading real estate investment software since 2000. It's fast, easy, and concise. Create rental property cash flow, rate of return, and profitability analysis presentations in minutes! Cap rates and GRM are automatically computed. Learn more at => http://www.proapod.com
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How to Create Revenue Projections to Determine Rental Property Profitability
When a real estate investor or analyst wants to determine whether a rental property is profitable and might offer a good investment opportunity or should be dismissed, they commonly evaluate the property's projected future revenues.
The idea is to estimate the cash flows and rates of return a rental property may produce for future years by projecting its income, operating expenses, and loan payment out for maybe ten years based upon some assumptions.
The concept is straightforward. Increase the income and operating expenses annually by some estimated percentage rate to arrive at a net operating income (income less expenses), then deduct the mortgage balance owed for that particular year to compute the property's cash flow and subsequent rates of return. The proforma income statement (or proforma) is generally the report used to project these revenues, and in this article, we'll discuss some simple basics to give you the idea. Please feel free to visit my website if you would like to see a sample proforma.
How to Create a Proforma You can choose one of two methods. You can use a spreadsheet or you can invest in a real estate investment software solution that provides the forms and will create a proforma income statement for you.
In any case, the important thing is to start the proforma with numbers that accurately reflect the property's current financial position, i.e., income, operating expenses, and loan payment. This will represent year one.
Next, make an estimate as to how much you think income and expenses will increase annually (use separate percentage rates for each if you wish) and multiply your starting numbers by these rates to calculate for year two, year two's numbers again for year three, and so on out as many years as you deem necessary (ten years is typical). Be sure to include the loan repayment for each of those years.
Finally, for each year, subtract the operating expenses from the income to determine the rental property's net operating income then subtract the loan payment to arrive at the cash flow (or more specifically, cash flow before taxes).
For a more elaborate income statement that shows cash flow after taxes, sale proceeds, cap rate, return on equity and so on, you will need to include tax information such as depreciation, mortgage interest, amortized loan points and the investor's marginal tax rate, a projected selling price for each of the years, and a round of additional computations for the rates of return.
Start with year one and then add each of the figures to the following years. You can inflate a sales price in exactly the same manner you did for income and expenses or select another way to project a sales price such as with a cap rate, gross rent multiplier, or set dollar amount. The depreciation rate depends on whether the rental property is residential (a home rental or apartments), or non-residential (commercial use). The loan will also have to be amortized so you can determine the amount of interest paid during each year.
You can find information regarding the depreciation schedules online if you're planning to construct your own proforma, otherwise a good real estate investment software solution will have it built in to the program and you will just have to fill in the forms.
Whether you choose to use real estate investment software or a spreadsheet, here's what you want to keep in mind about your statement.
1) You are essentially looking to analyze the cash flow and other performance measures resulting from changes to such variables as income, operating expenses, and property value over some number of future years.
2) Because it consists of projected estimates, don't rely solely upon a proforma income statement to make your investment decision.
3) Also, because it is speculative, you might not want to construct your proforma out further then ten years.
4) Always use income and operating expenses that are realistic to begin with and then use a reasonable percentage rate to inflate them annually. The same would be true with the projected selling price of the property.
To get a better idea about creating revenue projections for rental properties, you can see a completed sample proforma on my website. Here's to your real estate investing success.
About the Author
James Kobzeff is the developer of ProAPOD - leading real estate investment software since 2000. Fast, easy, and concise. Create cash flow, rate of return, and profitability analysis presentations for rental properties in minutes! Proforma automatically created. For investors and agents. Learn more => http://www.proapod.com
ProAPOD Investment Property Analysis Software Calculate Cap Rate
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