The Formula To Calculate The Overall Capitalization Rate Is Cap Rate Or Gross Rent Multiplier – Which Best Estimates Rental Property Value?

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

Market value and gross rental multiples are criteria often used by real estate agents and individual investors to evaluate the value of a rental property to determine whether or not it is the right price, and therefore a good investment opportunity.

Take, for example, the example when an agent or investor is trying to set a selling price for a certain income property. Others, after determining the cap rate (or capitalization rate) other similar income properties have sold for, will value the property in question based on the capitalization rate; while others, eager to determine the rental multiplier (or GRM) other similar properties have sold, will use its GRM to set the price.

So which one is better? At the end of the day, which rental property valuation method reflects the best financial performance of the property and promotes a smart investment decision?

Let’s consider both, and then make a decision.

Great value for money

This ratio (expressed as a percentage) measures the relationship between a property’s net operating income and its value. In other words, it states what percentage of gross operating income is in its value (or market value), and as a rule of thumb, whether the property can pay its way.

Here’s an idea. Because net operating income represents all income less operating expenses, NOI shows the amount of cash generated by the property that is available to pay off the loan. This is why lenders look closely at the property’s operating income when lending money.

The formula is correct: 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 for a 6.0% cap rate, then multiply the property’s operating income by 6.0 to determine its market value.

The limitation of this method (if you can call it a limitation) is that it is sometimes difficult to ascertain the actual operating cost of the home being sold and therefore to determine the actual (not just the published) rate of capital it was sold for.

As a rule of thumb, because it depends on individual markets, there is no such thing as a capitalization rate. What might make a rental property in one town or province 6%, might not be second-guessed in another.

Total Rent Multiplier

The GRM method (expressed as a number) measures the ratio between a rental property’s projected gross income (GSI) and its value.

Its advantage is that it is very easy to calculate. You don’t need a computer to calculate it, and in fact you can do it in your head. You simply divide the property’s market value by its GSI to make the calculation.

For example, if a property with $200,000 of projected gross income is sold for $1,000,000, it would sell for a rental multiple of 5.0 ($1,000,000/200,000). Conversely, multiply its GSI by 5.0 to arrive at its value ($200,000 x 5.0 = $1,000,000).

It was done that way. To determine the value of your subject property using this method, multiply its projected gross income by whatever ratio you deem appropriate for your market.

The disadvantage of this method is that, because it is based on the total planned income, it does not take into account the levels of occupancy and operating costs: both of which are, of course, important indicators about the general performance of the rental property.

As a rule of thumb, because it is also driven by the market, there is no universally correct number, although it would be surprising (and perhaps should raise suspicion) to see a GRM of less than 4 or more than 12.

Okay, so what’s the best way to determine the value of a rental property?

Although the rental multiplier is the simplest method of calculation, and can serve as a useful precursor to a more serious analysis of the property, most analysts would agree that the most reliable method of determining the value of a rental property is the rent-to-market method.

Still, you should not rely on the cost of capital alone to provide a true picture of the property’s profitability or make a real estate investment decision without accurately calculating all the numbers, rates of return, and cash flow scenarios yourself.

Remember that numbers can be used. When you are told how much property to buy for income based on the cap rate, be sure to reconstruct your raw data to make sure everything is revealed and nothing is hidden before you proceed with real estate investing.

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