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Income Capitalization Rate (Cap Rate), Gross Rent Multiplier (GRM) approach and Cash-on-Cash rate of return are the most often used methods to get a quick approximation of value of an investment property:
Income Capitalization Rate, aka, Cap Rate is the ratio between the first year Net Operating Income (NOI) and the purchase price of the property. The cap rate formula below can be used to derive a value of an investment property, when the cap rate and the net operating income are known. Another variation of the cap rate formula is to determine the cap rate of an investment property when the NOI is known and the price is fixed.
(Some investors use Cap Rate as a real estate investment rate of return (yield) to compare to what I could expect to earn on a Bond or CD. The difference being the effect of high inflation: a bond looses principal value and my money in a CD looses purchasing power, but a real estate investment portfolio appreciates even faster with inflation. Real estate is an excellent inflation hedge.)
Investment Value = NOI / CAP RATE
CAP RATE = NOI / Investment Value
Net Operating income (NOI) is calculated as follows:
Scheduled Gross Income + Other Income - Vacancy Factor + Credit Losses =
Gross Operating Income - Operating Expenses = Net Operating Income
Operating Expenses include: Property taxes, insurance, utilities, maintenance, management, supplies, home owners association dues, services such as home warranty policy and call out fees, etc.
Utilities separately metered for each unit can be billed to and paid directly by the tenant. Utility services not separately metered for each unit have to be added to operating expenses.
Landlords often add local municipal privilege taxes (sales tax on rental income) to the monthly rental charges to be paid by the tenant per the terms of the lease.
Once the NOI for an investment property has been determined, the following assumptions can be made: the lower the Cap Rate, the higher the Sales Price; the higher the Cap Rate, the lower the Sales Price. Sellers want buyers to accept the lowest possible Cap Rate. But from the buyer's point of view, the higher the Cap Rate, the more advantageous the purchase.
Pros: The main advantage of using a cap rate is its simplicity since it also accounts for vacancy and operating expenses.
Cons: The reliability of using a cap rate is limited because it only looks at a one year forecast and does not take into consideration any financing or tax implications.
Gross Rent Multiplier is used to determine market value of an investment property, before operating expenses, calculated by using the Gross Scheduled Income (GSI) = amount of annual rent received with 100% occupancy for year one, multiplied by the GRM for other rental properties in the area determined by a rent survey of the area. GRM can also be looked at as the number of years of rent generated by the property, before expenses, to return its acquisition cost.
First Year GSI x GRM = Investment Value
If an investor wants to quickly calculate the GRM for a potential investment, divide the asking price by the first year GSI. The higher the asking price is, the higher the GRM. Sellers generally try to sell their properties at the highest possible GRM. Buyers try to purchase investment properties at the lowest possible GRM. The lower the GRM, the more attractive the investment becomes to the buyer because it states the number of years rent earned by the property will return the cost of acquisition cost.
Pros: The GRM is a convenient tool because of its simplicity.
Cons: The usefulness of the GRM is limited by the fact that it does not take into account vacancy and uncollected rent, operating expenses, debt service, tax impact or income past the first year.
Cash-on-cash is another measurement of investment performance is called the cash-on-cash rate of return. This involves comparing an investor's initial investment to the potential before-tax cash flow that the investment property is likely to produce.
Before Tax Cash (Rental Income) / Initial Investment Cost = % Return
Pros: Cash-on-cash valuation takes into consideration vacancy and uncollected rent, operating expenses, and debt service.
Cons: Cash-on-cash valuation does not take into consideration anything past a first year forecast and does not take into account tax considerations.
As you can see, the formulas are quite simple to use. The difficulty in residential investment property analysis is getting reliable information. Many investors are not good record keepers and are unable to justify the expense of a bookkeeper or accountant. They may do repair work themselves and not track the expense or misplace receipts and/or are unable to produce documentation for maintenance work performed. An inspection will determine the present condition of the property and deferred maintenance, but there is no history of expenses to maintain the property in its present condition. In a multi-unit property, the owner may not have tracked occupancy by unit, so your Vacancy Factor should initially be higher until you have a rental history you can rely upon.
If this is the case, knowledge of expenses of similar properties in the area will be most helpful or you may use generally accepted "rules of thumb"when there is not sufficient or reliable actual or empirical data to draw upon. You will enhance the value of your investment by keeping thorough and accurate records. Contact Sam today so we can begin building your portfolio of Phoenix investment property while prices are as low as they are.