The capitalization rate and gross rent multiplier are measures regularly used by real estate agents and individual investors to assess the price of a rental property to determine whether or not it is priced correctly and therefore is a good investment opportunity.
Take, for example, an instance where the agent or investor attempts to set a sales price for a particular income property. Some, having determined the capitalization rate (or capitalization rate) that other properties of similar income have sold for, would price the property in question based on its capitalization rate; while others, equally diligent in determining the Gross Rent Multiplier (or GRM) that other similar properties have sold for, would use their GRM to set the price.
So which one is better? At the end of the day, which method of estimating the value of a rental property best measures the financial performance of the property and promotes a smarter investment decision?
Let us consider both, and then decide.
capitalization rate
This rate (expressed as a percentage) measures the relationship between a property’s net operating income and its price. In other words, it expresses what percentage rate a property’s net operating income is at its value (or sale price) and, as a general rule, whether a property has the ability to pay its own expenses.
Here’s the idea. Because net operating income represents all income minus operating expenses, the NOI indicates the amount of money produced by the property available to pay the mortgage. This is why lenders look closely at the property’s net operating income when making a loan.
The formula is simple: simply multiply the property’s NOI by whatever capitalization rate you think is appropriate to arrive at its value. For example, if similar properties are selling at a 6.0% capitalization rate, multiply the subject property’s net operating income by 6.0 to determine its market value.
The downside to this method (if you can call it a downside) is that it is sometimes difficult to confirm the actual operating expenses of a sold property, and therefore determine the actual capitalization rate (not just the published one) that it sold for. .
As a general rule, because it depends on individual market areas, there is no universal cap rate. What might make a rental income property a steal in one city or state at 6%, might not get a second look in another.
Gross Income Multiplier
The GRM method (expressed as a number) measures the relationship between a rental property’s scheduled gross income (GSI) and its price.
Its advantage is that it is very easy to calculate. You don’t even need a computer to calculate it, and in fact, you can probably do it in your head. Simply divide a property’s sales price by its GSI to do the calculation.
For example, if a property with a scheduled gross income of $200,000 sells for $1,000,000, it would have sold with a gross rent multiplier of 5.0 ($1,000,000/200,000). Instead, simply multiply your GSI by 5.0 to arrive at your price ($200,000 x 5.0 = $1,000,000).
This is how you do it. To determine the price of your subject property using this method, simply multiply your scheduled gross income by the ratio you feel is appropriate for your market area.
The downside to this method is that, because it is based on scheduled gross income, it ignores occupancy levels and operating expenses: both, of course, are important indicators of a rental property’s overall performance.
As a general rule of thumb, because it is also market driven, there is no universally correct number, although it would be surprising (and perhaps suspicious) to see a GRM less than 4 or greater than 12.
Okay, so what is the best method to determine the value of a rental property?
Although the gross rent multiplier is certainly the easiest method to calculate and can serve as a useful precursor to serious property analysis, most analysts would agree that the most reliable way to determine home value is Rental property is on the capitalization rate method.
Still, you should never rely on the cap rate alone to get a true picture of a property’s profitability or make a real estate investment decision without correctly calculating all the numbers, rates of return, and cash flow scenarios itself. same.
Remember that numbers can be manipulated. When you’re told how good an income property is to buy based on its cap rate, be sure to piece together your own raw data to make sure everything is out there and nothing is hidden before you actively pursue real estate investing.