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.

California's housing affordability falls

The percentage of households in California able to afford a median-priced home stood at 19 percent in February, a 6 percentage-point decrease from the same period a year ago when the group's housing affordability index was at 25 percent, according to a report released Thursday by the California Association of Realtors. The Realtors' February index improved 1 percentage point from January, when it stood at 18 percent.

The index measures the percentage of households that can afford to purchase a median-priced home in California. The minimum household income needed to purchase a median-priced home at $471,620 in California in February was $109,380, based on an average effective mortgage interest rate of 5.71 percent and assuming a 20 percent down payment, according to CAR. The minimum household income needed to purchase a median-priced home was up from $91,050 in February 2004, when the median price of a home was $391,550 and the prevailing interest rate was 5.74 percent. The minimum household income needed to purchase a median-priced home nationwide was $44,300 in February, based on a purchase price of $191,000.

At 38 percent, the High Desert region was the most affordable region in the state, followed by the Sacramento region at 24 percent. The Santa Barbara region was the least affordable in the state at 8 percent, followed by the Northern Wine Country region at 9 percent. The association's home price figures are based on surveys of its member Realtor organizations. They do not include the prices of all homes sold, such as those sold by owners or real estate agents who are not part of the California Association of Realtors.

Proposition 13; Proposition 60; Proposition 90

Under Proposition 13, the real estate tax on a parcel of property is limited to 1% of its purchase price, forever, until the property is resold. The proposition was passed, in part, due to homeowner anger at ever-increasing tax rates; this led to situations where senior citizens on fixed incomes could no longer afford to pay the property taxes on their homes as population and land value soared together in California.

If either spouse is over age 55, PROP 60 allows replacement of a primary residence with a new home of equal or lesser value (but see below) within the same county and transfer of the Prop 13 assessed valuation from the old home to the new property.

PROP 90 allows counties to elect to accept transfers of Prop 13 values for moves from other counties when a primary residence is replaced with a less expensive (but see below) home. If you are over 55 and move into a county which accepts Prop 90, you may take your old, lower Prop 13 value, regardless of from which county you move. Using Prop 90, you can sell your $400,000 San Francisco home [assessed value $80,000] and move to a new $300,000 home in San Mateo; the new San Mateo assessed value will be $80,000!

COUNTIES WHICH ACCEPT PROP 90 (Current as of 11/5/2004) Alameda, Los Angeles, Orange, San Diego, San Mateo, Santa Clara, and Ventura.

Props 60 and 90 apply if you "trade down" (i.e. the new home costs less than the sales price of the old home). In some cases you may buy for 10% more than the sales price of the old home. If you buy New Home 1st; then sell the Old Home, you must go down in price. If you sell the Old Home1st; then buy the New Home:

In 1st 365 days after the sale of Old Home, you may go up 5% in the purchase price of New Home. If you buy New Home more than 1 year from the sale of Old Home, but less than 2 years, you may go up 10%.