“I wish I knew this was a good deal” is a common statement from real estate investors who consistently miss out on good rental property deals. The process of determining which rental property is a good real estate investment can be incredibly frustrating and confusing, especially if you’re a new real estate investor.
While many factors, such as location and property type, determine how much a multifamily property is worth, nothing is as essential as the property’s financials.
As a real estate investor, knowing how to analyze an investment property is the first step to making wise real estate investment decisions. At Sage Real Estate, we utilize the 6-2-1 Sage Formula to run a financial analysis on rental properties.
It’s important to note that, ultimately, a financial analysis is not absolute. This means that each of the six metrics is going to give you a range of values on how much the property may be worth, and these metrics are not 100% objective because every property’s value is subjective based on many factors other than this financial analysis.
The first and second most important metrics that you need to use and consider are the Gross Rent Multiplier (GRM) and the Capitalization Rate (Cap Rate).
If you want to save the most time and analyze deals quicker than ever, we’ve got you covered with our very own Sage Real Estate Multifamily Rental Property Calculator. Using this calculator, you’ll be able to quickly and easily analyze any investment property using the same metrics that seasoned investors rely on.
Gross Rent Multiplier: A Simple and Fast Method of Analyzing Rental Properties
The Gross Rent Multiplier, also known as GRM, is a great start to realizing whether a property is a good deal or not. This is the top metric used by beginner and seasoned real estate investors to choose the best real estate deals and analyze the real-time financial performance of their rental properties.
Here’s what you need to know about the Gross Rent Multiplier (GRM):
- The GRM applies to all rental property types, from single-family homes to multifamily investment properties.
- Each area, such as a neighborhood or city, has a different GRM that applies to the properties in that area.
- The GRM is market-derived. This means that the area’s market determines the GRM, not a person or organization.
- The goal is to buy a property that’s at or below the market’s GRM.
Finding the Gross Rent Multiplier in your area.
Experienced real estate investors know the GRM of their area. If you really know your market, you’ll know the GRM for the properties in your location. However, if you’re a new investor and you’re new to your area, then the best way to figure out the GRM is by asking your local multifamily real estate broker. Any skilled broker should know their area’s Gross Rent Multiplier.
Also, be aware that there’s a difference between residential real estate agents who deal with single-family homes and condos versus real estate brokers who deal with multifamily rental properties.
If you want to calculate the GRM of your area or neighborhood, you can simply reverse-engineer it by looking into past sales of rental properties in that area. When you know the property’s value and gross annual rents, then you can easily calculate the GRM.
The Gross Rent Multiplier Formula:
- Gross Rent Multiplier = Property Value / Gross Annual Income
Finding a Property’s Value Using the Gross Rent Multiplier
For this example, we’re going to consider a four-unit property.
1. Calculate the gross rental income of the property.
- Unit A: $1,350 per month
- Unit B: $1,500 per month
- Unit C: $1,700 per month
- Unit D: $950 per month
- Total Gross Monthly Income: $5,500
- Total Gross Annual Income $66,000
2. Figure out the Gross Rent Multiplier of the property’s area.
For this example, the GRM of the neighborhood is 10.
3. Calculate the Property’s Value
- Property Value = Gross Annual Income x Gross Rent Multiplier
- $660,000 (Property Value) = $66,000 (Gross Annual Income) x 10 (Gross Rent Multiplier)
The Gross Rent Multiplier Helps Determine a Good Deal
If the property is listed for sale at around $660,000, then you know that you’re buying it at market value.
However, if the property is priced at around $726,000, then you might be overpaying for it because the value brings the GRM up to 11.
- $726,000 (Property Value) = $66,000 (Gross Annual Income) x 11 (Gross Rent Multiplier)
If the property is listed with a GRM of 9 at around $594,000, then you’re paying below market value, and it looks like a good deal.
- $594000 (Property Value) = $66,000 (Gross Annual Income) x 9 (Gross Rent Multiplier)
The GRM of a specific neighborhood or city is determined by the market. Whether it’s a buyer, seller, or real estate agent, nobody can make up the GRM of that neighborhood because there’s enough data to show you the right GRM.
If you’re shopping for a rental property, the smart decision is to buy a property that is priced under the GRM because that’s when you’re buying into equity starting from day one.
In the same example, if you bought the property at $594,000 with a GRM of 9 when the market value is at $660,000 with a GRM of 10, you’ve not only saved the difference of $66,000, but you’ve also earned a year’s worth of income on Day 1 instead of Day 365.
GRM Indicates How Much the Property Value Increases as Rent Increases
The second utility of the GRM is that it helps you know how much you’ve increased your property’s value after increasing rental income. If you’ve made strategic improvements to your units and added extra amenities that will allow you to increase the rental income of the property, then you’ll be able to determine how much your hard work and smart decisions have added to your property’s equity or value.
Using the same example as before, you were able to increase the monthly rental income by $100 for each of the four units.
- Unit A: $1,450 per month
- Unit B: $1,600 per month
- Unit C: $1,800 per month
- Unit D: $1,050 per month
- New Total Gross Monthly Income: $5,900 (+$400)
- New Total Gross Annual Income $70,800 (+$4,800)
Many new real estate investors might think that they’ve increased the rental property’s value by only $4,800. But that’s not how it works. We know that any increase in gross rental income equates to a multiplier like the GRM.
So using the same formula, you can calculate the added value based on the neighborhood’s GRM and new Gross Annual Income.
- $48,000 (Added Value) = $4,800 (Gross Annual Income) x 10 (Gross Rent Multiplier)
By simply increasing the monthly rental income by $400, you’ve already added $48,000 of equity to your property.
This is how wealth is created by using the GRM to your benefit. This is how experienced investors can easily tell whether a property is a good deal or not.
Analyzing a Rental Property Using the Capitalization Rate (Cap Rate)
The second metric often and commonly used by real estate investors, real estate agents, brokers, and appraisers is the capitalization rate or cap rate. Learning about Cap Rates is crucial to finding good deals and negotiating with sellers because if you don’t then this number can be used against you.
Cap Rates are calculated as the rate of return based on the value of the property or the ratio between the net operating income and the property’s purchase price. Just like the Gross Rent Multiplier, Cap Rate is market-derived. This means that the area’s market determines the Cap Rate, not a person or organization.
Capitalization Rate Formula:
- Capitalization Rate = Net Operating Income (NOI) / Property Valuation
How is Cap Rate different from the Gross Rent Multiplier?
Just like every other metric, Cap Rate and GRM showcase the potential value of a property in different ways. While the Gross Rent Multiplier is used to estimate the rental property’s value based on the gross rental income, the capitalization rate (cap rate) is used to determine what the property’s current value is or should be based on the net operating income (NOI).
Unlike the GRM, which is used for all types of rental properties, Cap Rate is typically only used for properties with two or more units (not single-family homes or condos).
How to Calculate Net Operating Income (NOI)
Net Operating Income Formula:
- Net Operating Income = Gross Annual Income – Annual Operating Expenses
What type of operating expenses are included?
- Taxes – Make sure to calculate taxes based on the current price/sale, not the previous sale of the property
- Repairs
- Insurance
- Management – In case you have a property management company
- Utilities
- Payroll – For properties around 16 units or more
Remember that NOI typically only includes normal operating expenses, and excludes the mortgage payments for the property. Debt service is not included in this calculation because every real estate investor has a different financial situation and mortgage loans, plus it allows you to make an apples-to-apples comparison between rental properties.
If you want to speed up your calculation process, you can just input the operational expenses as 30% of the gross rental income because that’s generally what the average operational expenses add up to.
Using the same four-unit building as an example earlier, we can calculate NOI using 30% of the gross annual income as operating expenses:
- NOI = $66,000 – ($66,000 x 0.30)
- NOI = $66,000 – $19,800
- NOI = $46,200
Now that you know the Net Operating Income or NOI, you can divide that number
- by the property’s value to obtain the Cap Rate; or
- divide it by the Cap Rate to obtain the property’s value.
You only need two numbers in order to obtain the third number. When you know the NOI, you can easily know either the cap rate.
- 6% (Cap Rate) = $46,200 (NOI) / $770,000 (Property Valuation)
- $770,000 (Property Valuation) = $46,200 (NOI) / 6% (Cap Rate)
What is a good Cap Rate?
It all depends on the location. Real estate is all about location, and that applies to Cap Rates as well as it applies to GRM. If you look at certain areas outside of Southern California, a Cap Rate of 9% or more might be normal. However, within Southern California, a Cap Rate of 7% would be extremely rare.
Just like the GRM, you can determine the Cap Rate of a specific neighborhood or area by working backward and calculating it based on previous property sales. You can also save time by contacting your local real estate broker to ask about the Cap Rates of neighborhoods in the area.
The golden rule is to purchase a property with a higher Cap Rate, because it essentially means that you’re getting a better return on your investment.
The higher the Cap Rate, the lower the purchase price, so that means you’re winning as a smart investor:
- $660,000 (Property Valuation) = $46,200 (NOI) / 7% (Cap Rate)
- $770,000 (Property Valuation) = $46,200 (NOI) / 6% (Cap Rate)
- $840,000 (Property Valuation) = $46,200 (NOI) / 5.5% (Cap Rate)
- $924,000 (Property Valuation) = $46,200 (NOI) / 5% (Cap Rate)
- $1,026,666 (Property Valuation) = $46,200 (NOI) / 4.5% (Cap Rate)
For example: if the market Cap Rate in a specific area is 6% and you purchased a property with a 7% Cap Rate, then you’ve scored yourself a good deal!
Cap Rate Also Indicates How Much the Property Value Increases as Rent Increases
Just like the GRM, Cap Rate also helps you know how much you’ve increased your property’s value after increasing rental income.
Using the same example as before, you were able to increase the monthly rental income by $100 for each of the four units.
- Unit A: $1,450 per month
- Unit B: $1,600 per month
- Unit C: $1,800 per month
- Unit D: $1,050 per month
- New Total Gross Monthly Income: $5,900 (+$400)
- New Total Gross Annual Income $70,800 (+$4,800)
So using the same formula, you can calculate the added value based on the neighborhood’s Cap Rate of 6% and new NOI of $3,360.
- Additional NOI = $4,800 – ($4,800 x 0.30)
- Additional NOI = $4,800 – $1,440
- Additional NOI = $3,360
By simply increasing the monthly rental income by $400, you’ve already added $56,000 of equity to your property.
- $56,000 (Additional Value) = $3,360 (Additional NOI) / Cap Rate
- New Property Value = $770,000 + $56,000 = $826,000
Limitations of Using Cap Rate
Not all investment metrics are created equal, and that’s why good investors use more than one metric to determine whether they’re getting a good deal or not. In the world of multifamily and commercial real estate, for some reason, people give Cap Rate so much weight in their decision-making. The problem is that Cap Rate has a couple of limitations:
- You need to realize that the Cap Rate only reflects a limited period of time. It’s a snapshot of the property for a 12-month period. When determining the Cap Rate, twelve months of net operating income is calculated. Since most real estate investors know that real estate is a long-term investment, they hold their properties for longer than a few years. The Cap Rate calculation alone does not tell the story of whether the property is improving or declining in financial performance. It only shows the return or value based on one 12-month income scenario, which may have already changed since the data was gathered.
- Operating expenses could vary from building to building. Depending on the real estate broker or seller, you may not be seeing the whole picture because expenses can sometimes be manipulated.
If you want to save the most time and analyze deals quicker than ever, we’ve got you covered with our very own Sage Real Estate Multifamily Rental Property Calculator. Using this calculator, you’ll be able to quickly and easily analyze any investment property using the same metrics that seasoned investors rely on.
