How to Value a Rental Property

There are three common formulas for valuating a rental property, and they are as follows:

Gross Rent Multiplier 

The Gross Rental Multiplier (GRM) is the ratio of the price of a real estate investment to its annual rental income before expenses.  The GRM is easy to calculate, but isn’t a very precise tool for ascertaining value since it does not take into account either expenses or financing. It is, however, an excellent first quick value assessment tool to see if further more detailed analysis is warranted. In other words, if the GRM is too high or low compared to recent comparable sold properties, it probably indicates a problem with the property or gross over-pricing.

The formula here is Cost divided by Gross Operating Income = Gross Multiplier

So take the cost (or Sales Price) of the property and divide that number by the Gross Operating Income (annual income less vacancy rate) and you have your GRM.


Capitalization Rate (or Cap Rate)

By using other properties’ operating income and recent sold prices, the capitalization rate is determined and then applied to the property in question to determine current value based on income.

The formula here is Net Operating Income divided by Cost = Cap Rate

The Cap Rate needs to be higher than your loan amount to help ensure you are in a financial position to afford your mortgage.  The Cap Rate method is better than the Gross Rent Multiplier Method because it takes expenses into account.  This formula, however, is good for those Triangle Real Estate Investors who will be purchasing the property in cash.


Cash-on-Cash Formula (my personal favorite)

The Cash-on-Cash rate of return provides an easy way for real estate investors to compare the profitability of similar income-producing properties, or as a way to gauge one investment opportunity against another quickly

Cash-on-cash return measures the ratio between anticipated “first-year cash flow” to the amount of “initial cash investment” made by the real estate investor to purchase the rental property. Hence, cash on cash is always expressed as a percentage.

Terms

Cash Flow Before Taxes (CFBT) is the amount of money the property is expected to generate during the first year of operation (less real estate taxes).

The initial cash investment (sometimes called the cost of acquisition) is the total amount of cash invested by the investor to acquire the property such as down payment, loan points, escrow and title fees, appraisal, and inspection costs

The formula here is Cash Flow Before Taxes (CFBT) divided by Cash Invested = Cash on Cash

CFBT is the annual rent, less vacancy rate, less operating expenses and less annual debt service.

One shortcoming is the fact that cash on cash does not take into account time value of money.  As such, the return must be restricted to simply measuring an income property’s first year cash flow, and not its future year’s cash flows.

If the cashflow is good enough, all other factors should equal out.

Financial Benefits to Owning Triangle Real Estate Investment Properties

There are basically four financial benefits to owning Triangle Real Estate Investment Properties:

1) Income by CFBT, or Cash Flow Before Taxes

2) Principal Reduction

3) Tax Savings by Depreciation

4) Appreciation

I will address each individually below.

1.  CFBT/Cash Flow Before Taxes:  To calculate the CFBT, you first need to know what your Gross Operating Income is.

Gross Operating Income (GOI) = Annual Rent (based upon the unit being 100% leased for the year), less your vacancy rate.
So if your unit leases for $1,000 per month and you historically have a vacancy rate of 5%, then your Gross Operating Income will be:

$1,000,00 x 12 months = $12,000.00
$12,000.00 x 5% = $600.00
$12,000.00 – $600.00  = $11,400.00
GOI = $11,400.00

Now that you know your GOI (Gross Operating Income), you subtract from that your Operating Expenses.  Operating Expenses can include such costs as:

  • real estate taxes
  • repairs
  • homeowner association dues
  • leasing fees
  • management fees
  • homeowner insurance
  • utilities
  • advertising
  • supplies
  • miscellaneous (anything else).

Let’s now say that your annual operating expenses will run about $5,400.00 per year.

So, you take your $11,400.00 (GOI) and subtract the $5,400.00 (Operating Expenses), you now have $6,000.00…and this is known as your Net Operating Income.

From your Net Operating Income, you will now subtract your Debt Service.  Debt Service is just a fancy term for your mortgage.  It includes your mortgage (principal and interest) over a 12 month period.

Presuming you pay $3,600.00 per year in Debt Service (that’s $300.00 per month x 12 months), you will subtract that $3,600.00 from your Net Operating Income of $6,000.00 and you now have $2,400.00.  Another term for this $2,400.00 is your Cash Flow Before Taxes.

2.  Principal Reduction:  This is the decrease in the principal amount you owe on your loan.  When you make a payment to your lender every month, part of that payment is allocated to the principal, and part of it to the interest that the lender is charging you. So therefore you are ‘paying down’ or ‘reducing’ the amount of the loan each month with each payment.

3.  Tax Savings by Depreciation:  We will get into depreciation a little more in a different blog post, but basically, you are able to write off the Personal Property Value, Building Value and Land Improvement Value of your property over ‘x’ amount of time.  The ‘x’ amount is determinant upon each category.  So with this depreciation, you SHOULD be able to save money on your taxes each year.

4)  Appreciation:  This is where the value of your real estate investment increases each year.  The percentage amount has been kinda screwy these last couple of years, but once things settle down, the appreciation of your real estate investment should equate to at least 2% annually.