Cap Rate or Gross Rent Multiplier: How Should You Estimate Rental Property Value?
Two methods commonly used by real estate agents and individual investors who want to estimate the value of rental property value are cap rate and gross rent multiplier.
Whereas some, for instance, would set a selling price for a particular income property using the cap rate (or capitalization rate) method, others use the gross rent multiplier (or GRM) method.
But at the end of the day, which method best measures the property’s financial performance and profitability and therein promotes a smarter investment decision?
In this article we’ll consider both, and then decide.
Capitalization Rate
Cap rate measures the relationship between a property’s net operating income and its price and therein expresses what percentage rate a property’s net operating income is to its value (or sale price). In essence, and as a rule of thumb, it shows whether a property has the ability to pay its own way.
Here’s the thought. Because net operating income represents all income less operating expenses, NOI represents the amount of money the property produces to pay the mortgage. This is why lenders look closely at the property’s net operating income when making a loan.
Making the calculation is straightforward: To estimate the value of rental income property, simply multiply the property’s NOI by whatever cap rate you deem appropriate for your market area. For example, if similar income 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.
One disadvantage of this method 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.
As a 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% might suggest a great opportunity, whereas it might appear over priced in another.
Gross Rent Multiplier
The GRM method 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 simply divide a property’s selling price by its GSI. For example, if a property sells for $1,000,000 with $200,000 gross scheduled income, it has a gross rent multiplier of 5.0 ($1,000,000 / 200,000). On the other hand, to calculate its value you would multiply its GSI by 5.0 ($200,000 x 5.0 = $1,000,000).
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, should be considered during the real estate analysis.
As a rule of thumb, also because it is market-driven, there is no universally correct number, though it would be surprising (and perhaps suspicious) to see a GRM lower than 4 or maybe higher than 12.
Okay, so which is it? Which method is the better way to determine a rental property’s value?
Gross rent multiplier is the easier method to calculate, and certainly can serve as a useful precursor to a serious property analysis, but 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 let’s be clear. 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. When told how great a buy an income property is based upon its cap rate, just be sure to reconstruct your own raw data. Before you actively pursue any real estate investment further, insure that all is revealed and nothing is concealed.
Author: James Kobzeff, May 15th, 2009
