Cap rate (or capitalization rate) and gross rent multiplier (GRM) are two popular real estate investing methods real estate investors and agents commonly use to estimate the market value of rental income properties – both for selling and buying purposes.
At the end of the day, though, which method – cap rate or gross rent multiplier – best measures the property’s financial performance and profitability and therein is likely to promote a smarter real estate investment decision?
In this article we’ll consider the pro’s and con’s of both and then show you what the professionals think.
Capitalization Rate
Cap rate measures the relationship between a property’s net operating income (NOI) and its price – therein expressing what percentage rate a property’s net operating income is to its value (or sale price).
Here’s the thought. Because net operating income represents all income less operating expenses, net operating income represents the amount of money the property produces to pay the mortgage. So it basically shows whether a rental property has the ability to pay its own way. This is why lenders look closely at the property’s net operating income when making a loan.
Formulations
Cap Rate = Net Operating Income / Market Value
Using this method to arrive at rental property market value requires some research. You would have to establish what the average cap rates for similar income properties in the local area are in addition to the net operating generated by the subject rental property.
Market Value = Net Operating Income / Capitalization Rate
Pro’s and Con’s
The advantage of using cap rate – given that it relates to net operating income – is that it accounts for the rental property’s annual vacancy allowance and operating expenses. Moreover, it is routinely used by bank appraisers, county tax assessors, and commercial real estate brokers so it’s a widely-accepted valuation method.
One disadvantage is that it’s sometimes difficult to confirm a sold property’s actual operating expenses and therefore difficult to determine with any degree of accuracy the actual – not merely the published – capitalization rate the property sold for.
Rule of Thumb
Capitalization rate depends on individual market areas. So there is no such thing as a universal rate. In one city or state a rental property at 7% cap rate might suggest a great opportunity, whereas it might appear over priced in another.
Gross Rent Multiplier
The gross rent multiplier method measures the ratio between a rental property’s gross scheduled income (GSI) and its price.
Formulations
Gross Rent Multiplier = Market Value / Gross Scheduled Income
Using GRM to arrive at income property market value also requires some research. You would have to establish what the average gross rent multiplier has been for recently sold income properties in the local area as well as settling the gross scheduled income generated by the subject property.
Value = Gross Scheduled Income x Gross Rent Multiplier
Pro’s and Con’s
The advantage here is that gross rent multiplier is quick and easy to calculate.
The disadvantage of the GRM method is that – because it is based upon gross scheduled income – it ignores occupancy levels and operating expenses. Both of which, of course, that should be considered during the real estate analysis.
Rule of Thumb
Because GRM is market-driven, there is no universally correct number – though it would be surprising (perhaps suspicious) to see a GRM lower than 4 or maybe higher than 12.
Conclusion
Okay, so which method is the better way to determine a rental property’s market value?
Most analysts tend to agree (including appraisers and tax assessors) that the cap rate method is the more reliable way to determine rental property value. But it comes with a caveat.
You should never rely on capitalization rate alone to provide a true picture of a property’s profitability. Before making any real estate investment decision, always compute all the numbers, rates of return, and cash flow scenarios for yourself. After all, numbers can be contrived so always reconstruct your own raw data. Before you actively pursue any real estate investment further, insure that all is revealed and nothing is concealed.
So You Know
ProAPOD real estate investment analysis software solutions automatically calculate cap rate and gross rent multiplier and then post the results in the appropriate real estate analysis reports.
