Determining the Value of Investment Property

Two commonly used methods of determining the value of an investment property are the Gross Rent Multiplier (GRM) method and the Income Capitalization or Cap Rate method.

Gross Rent Multiplier (GRM)

The investment value of a property can be calculated using the estimated Gross Scheduled Income (GSI) for year one, multiplied by a factor known as the Gross Rent Multiplier (GRM). ("Gross Rents" is just another way of saying Gross Scheduled Income.)

First-year GSI x GRM = Investment value of property

The gross rent multiplier used in evaluating investment property is typically derived from comparable properties in the marketplace and may be adjusted by the investor to reflect his or her specific requirements.

Using the Gross Rent Multiplier to Determine Investment Value

Example:

Suppose a potential buyer's gross rent multiplier (GRM) requirement is 10. (This means the investor will pay no more than 10 times the gross scheduled rent to purchase an investment property.) The property the buyer is considering has an estimated first-year gross scheduled income of $100,000. The investment value, or the amount this investor would be willing to pay for this property, is:

$100,000 x 10 = $1,000,000

Pros and Cons in Using a Gross Rent Multiplier:

Pros: The gross rent multiplier is a convenient tool because of its simplicity.

Cons: The usefulness of the gross rent multiplier 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.


Capitalization Rate (Cap Rate)

The value of an investment property can be determined by its ability to produce cash returns. After paying all expenses, except principal and interest payments, the remaining cash flow is called the Net Operating Income (NOI). NOI is most commonly used in conjunction with a cap rate to determine property value.

Cap Rate

The cap rate is the ratio (expressed as a percentage) between purchase price and the first-year net operating income (NOI) of the property.

Determining the Cap Rate of an Investment

Investors use cap rates to measure investment performance:

Net Operating Income (NOI)/Purchase Price = Cap Rate

Example: An investment property selling for $1,000,000 with an estimated first-year NOI of $100,000 would have a capitalization rate of 10%.

$100,000/$1,000,000 = .10 or 10%


Using a Cap Rate to Determine Investment Value

A variation of the cap rate formula can be used to solve for investment value (price) when the cap rate and the net operating income are known.

Example

Suppose a potential buyer is looking at a property listed for $1,000,000 with an estimated first-year NOI of $100,000. After looking at the cap rates of similar properties, the buyer has decided on a cap rate requirement of 10%. We can use the formula below to determine the purchase price he would be willing to pay.

Income (NOI) /Cap Rate = Purchase Price

$100,000/.10 = $1,000,000

Pros and Cons in Using a Capitalization Rate (Cap Rate):

Pros: The main advantage of using a cap rate is its simplicity. 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.