Cap Rate Or Gross Rent Multiplier: Which Is Best When Real Estate Investing?

By Author: James Kobzeff
Total Articles: 44
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Cap rate and gross rent multiplier are each a method of measurement regularly used by real estate agents and individual investors to evaluate the price of rental properties in order to determine whether the price is good enough to make it a good investment opportunity.
For example. Whereas some agents and investors, having researched what other similar properties have sold for, use the capitalization rate method to determine and set a price for rental properties, others rely on the gross rent multiplier (or GRM) method.
So at the end of the day, which is better? Which method for estimating a rental property's value is the better measurement of a property's financial performance and more likely to lead to a smart investment decision?
Let's look at both.
Capitalization Rate
This rate (expressed as a percentage) measures the relationship between a property's net operating income and its price. In other words, it expresses what percentage rate a property's net operating income is to its value (or sale price), and as is a rule of thumb, whether a property has the ability to pay its own way.
Here's the ...
... idea. Because net operating income represents all income less operating expenses, NOI indicates the amount of money produced by the property available to pay the mortgage. This is the reason why lenders look closely at the property's net operating income when making a loan.
The formula is straightforward: To arrive at its value, you simply multiply a property's NOI by whatever cap rate you feel best reflects the rate in your market area. If similar income properties in your area have sold at a cap rate of 6.0%, for instance, you would compute a value for the subject property by multiplying its net operating income by 6.0.
The disadvantage of this method (if you can call it a disadvantage) is that it's sometimes difficult to confirm a sold property's actual operating expenses and therefore to determine the actual (not merely the published) capitalization rate it sold for. A good work-around is to get the market rate from a local appraiser.
There is no such thing as a universal cap rate because it will vary with individual market areas; whereas one property might be considered a steal at 6% in Los Angeles, for instance, it might not even get a second look in Raleigh.
Gross Rent Multiplier
The GRM method measures the ratio between an investment property's gross scheduled income (GSI) and its price and is expressed as a number.
The advantage of using this method is that GRM is very easy to calculate. You don't even need a computer to compute it, and in fact can probably do it in your head. You simply divide a property's selling price by its GSI to make the calculation.
For example, if a property with $200,000 gross scheduled income sells for $1,000,000, it would have sold at a gross rent multiplier of 5.0 ($1,000,000 / 200,000).
Conversely, to arrive at a property's value using this method, you simply multiply its GSI by whatever GRM you determine is appropriate for your market area (say it is 5.0): $200,000 x 5.0 = $1,000,000.
Nonetheless, though it is easy to compute, the disadvantage of using this method is that gross scheduled income does not account for occupancy levels and operating expenses (both of which are important indicators of a rental property's overall performance).
As a rule of thumb, because it is also market-driven, there is no universally correct number, though it would be surprising (and perhaps should raise suspicion) to see a GRM lower than 4 or higher than 12.
Okay, so which method is the best way to arrive at a rental property's value?
Though gross rent multiplier is certainly the easier method to calculate, and can serve as a useful precursor to a serious property analysis, most analysts would agree that the more reliable way to determine rental property value is with the cap rate method. Fair enough.
Still, you should never rely on capitalization rate alone to provide a true picture of a property's profitability or make a real estate investment decision without correctly computing all the numbers, rates of return, and cash flow scenarios for yourself.
Remember that numbers can be manipulated. When you are being told how great a buy an income property is based upon its cap rate, always reconstruct your own raw data to insure that all is revealed and nothing is concealed before you actively pursue the real estate investment further.
James Kobzeff is the developer of ProAPOD - superior real estate agent software solutions since 2000. Create rental property cash flow analysis and marketing presentations in minutes! Go to => www.proapod.com