Cap Rate Or Gross Rent Multiplier – Which Best Estimates Rental Property Value?

September 24, 2016

Gross Out

Cap rate and gross rent multiplier are measures regularly used by real estate agents and individual investors to evaluate the price of a rental property in order to determine whether it is, or is not, priced correctly and therefore a good investment opportunity.

Take, for example, an instance when the agent or investor is attempting to set a selling price for a particular income property. Some, having determined the cap rate (or capitalization rate) other similar income properties have sold for, would price the subject property based upon its capitalization rate; while others, just as diligent to determine the gross rent multiplier (or GRM) other similar properties have sold for, would use its GRM to set the price.

So which is better? At the end of the day, which method of estimating a rental property’s value best measures the property’s financial performance and therein promotes a smarter investment decision?

Let’s 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 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. Because net operating income represents all income less operating expenses, NOI indicates the amount of money produced by the property available to pay the mortgage. This is the reason why lenders look closely at the property’s net operating income when making a loan.

The formula is straightforward: Simply multiply the property’s NOI by whatever cap rate you deem appropriate to arrive at its value. For example, if similar properties are selling at a 6.0% cap rate, then multiply the subject property’s net operating income by 6.0 to determine its market value.

The disadvantage of this method (if you can call it a disadvantage) is that it’s sometimes difficult to confirm a sold property’s actual operating expenses and therefore to determine the actual (not merely the published) capitalization rate it sold for.

As a rule of thumb, because it depends on individual market areas, there is no such thing as a universal capitalization 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 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, and in fact can probably do it in your head. You simply divide a property’s selling price by its GSI to make the calculation.

For example, if a property with $ 200,000 gross scheduled income sells for $ 1,000,000, it would have sold at a gross rent multiplier of 5.0 ($ 1,000,000 / 200,000). Conversely, just multiply its GSI by 5.0 to arrive at its price ($ 200,000 x 5.0 = $ 1,000,000).

That’s how it’s done. To determine a price on your subject property using this method, just multiply its gross scheduled income by whatever ratio you deem appropriate for your market area.

The disadvantage of this method is that, because it is based upon gross scheduled income, it ignores occupancy levels and operating expenses: both of which, of course, important indicators regarding the overall performance of a rental property.

As a rule of thumb, because it is also market-driven, there is no universally correct number, though it would be surprising (and perhaps should raise suspicion) to see a GRM lower than 4 or higher than 12.

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.

Still, 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 that numbers can be manipulated. When you are being 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.

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