Before you say 'Investment Property' - can you spell GRM?  How about CAP rate?
by Kaushik Sirkar, Chandler REALTOR®
Chandler AZ Real Estate

Whenever people make investments they have various methodologies by which they measure the result.  Different types of investments have different terminology.  Terms such as yield and rate of return are common with stocks, bonds and assorted other investment vehicles.  Measuring the result of your income producing properties is typically performed using certain other industry specific terminology.

When dealing with income producing properties, ideally the investor will want to quantify the inherent 'VALUE' of said property as a key factor in determining potential yields.  One simple factor is often used in an attempt to assign a value to the income producing property in question.  That is the Gross Rent Multiplier (GRM) which is equal to the Sales Price divided by Gross Rent.

                                                     GRM = Sales Price / Gross Rent

The beauty of the GRM lies in its simplicity and ease of use.  The GRM for a property may be calculated just like that - hence multiple properties may have their GRMs compared very quickly for an approximation of relative VALUE (these can be back of the envelope calculations done on a moments notice).  The problem with GRM also lies in its simplicity.  It does not take into account other factors such as additional operating expenses, vacancies, etc.  For a more detailed analysis of VALUE in investment properties, folks use the CAP RATE (Capitalization Rate) where

                                                     CAP RATE = Net Operating Income (NOI) / VALUE

To truly understand exactly how CAP RATEs are determined, one must understand all the components of NOI.  I will outline all the relevant terms and their relationships below

          CAPITALIZATION

          Scheduled Gross Income (100% Occupancy)

-         Vacancies (% of Gross Income)

-         Credit Losses (% of Gross Income)

=        Effective (Adjusted) Gross Income (AGI)

-         Expenses

=        Net Operating Income (NOI)

-         Adjusted Debt Service (ADS)

=        CASHFLOW

/         Downpayment

=        Cash-on-Cash Return (x100)

Want a simple example to help illustrate GRM and CAP Rate?  For GRM, lets say you have a property (property A) with a sales price of $100,000 and a gross monthly rent of $1000.  The GRM (monthly) would be 100.  Lets say your client was considering purchasing another property (property B) that was also $100,000 but had a gross monthly rent of $1100.  The GRM in this case drops to about 91 and suggests property B is the better VALUE.  As you can see, a very simple calculation that can be performed for quick and cursory comparisons between properties.

Lets take property A again and go annual for CAP Rate.  $12,000 gross income, 1 month of vacancy ($1000) and $1000 in credit losses.  This leaves an AGI of $10,000.  Subtract repair expenses of say $1000 for the year and you are left with a NOI of $9000.  Take away another $6000 in ADS (mortgage payments) and you are down to a CASHFLOW of $3000.  Finally divide cashflow by your, lets say 10% downpayment, or $10,000 and you are left with a Cash-on-Cash return of 30%.  Going back to the NOI of $9000, and your purchase price of $100,000 - you are left with a CAP RATE of 9%.  Lets look at another property - property C.  Lets say property C is located in a high crime part of town and thus has much higher vacancies - 3 months or $3000 worth.  That makes AGI go down to $8000 and NOI down to $7000.  Your CAP RATE has just gone down to 7%.  Would you pay the same amount of money for properties A and C?  No way!  For it to compete, property C needs to have a HIGHER CAP Rate!  Also note that per GRM - properties A and C would have appeared equal....

I hope my brief math lesson hasn't bored you!  Just trying to illustrate how GRM is a great, yet SIMPLE analysis tool.  CAP RATE is potentially a more thorough tool.  If one property has a higher CAP RATE - that unto itself is not necessarily justification to purchase it.  Higher CAP Rates may often be found in run down/high crime areas - a requirement for the property to compete with those that have lower CAP Rates but are located in better parts of town.

Thanks for Reading :)

Kaushik Sirkar, Chandler Realtor
http://www.homesphx.com