Analyzing Investment Properties

If you have had any exposure to the world of Real Estate, you will have heard of two very important indicators, the capitalization rate and the gross rent multiplier. In market reports, the two indicators are usually placed side by side. In this short article I will detail the importance and significance of both indicators.

A capitalization rate, also known as cap rate, is simply the net operating income divided by the investment you make on the property. It is a simple percentage that helps determine whether a purchase is a sound investment. In order to calculate the cap rate, you first have to add up all the separate incomes of a building, i.e. rent, retail income, tax reimbursements, etc. You also have to calculate the total expenses. Usually, when making a purchase, that information will be available through the listing agent. Expenses are incurred through taxes, operating expenses and miscellaneous fees such as a superintendant or a management fee.

A big difference between financing a property and buying it all-cash is when you finance a property, the mortgage payments go into calculating the monthly investments. Oddly enough, sometimes it makes more sense to take out a mortgage on a property. Assuming you get a good rate and do not have to pay a large down payment, it might be financially beneficial to take out a mortgage. Once you have the total monthly or yearly income and the total monthly or yearly expenses, simply subtract the expenses from the income and you will have the net operating income. When you divide the net yearly operating income by the money you put down on the property, you will get a percentage. That percentage is an indicator of how sound an investment is. If the percent is negative, you are losing money. If it is positive, you have to make sure that it is above a certain threshold.

Usually cap rates of 5% and higher are considered “good”.

A gross rent multiplier is a number that one can only use if they have market data from the surrounding neighborhood. Put simply, one can figure out a gross rent multiplier by dividing the sales price of a property by the monthly income. Once one has a number of such multipliers, one can average them to find an average rent multiplier. Using this number, it is easy to figure out whether a property is a viable investment. If, let’s say, the average GRM for an area is 12 and you are considering purchasing a property with a monthly income of $12,000. Multiplying the GRM by the monthly income yields $144,000. However, the property is being sold for $200,000. This shows a huge discrepancy between the estimated market value and the actual market value. If the actual market value is higher than the estimated market value, the property is not a sound investment. If the actual market value is lower than the estimated value, then it makes sense to invest into the property.

Using these two indicators will allow an investor to judge whether a certain property is worth purchasing. While both of them are powerful tools separately, used together they give a very good feel for the viability of an investment.