Ronald Bachner has 30 years experience in building inspection, safety, and real estate experience. He enjoys local theater for relaxation.
Passive Income, Anyone?
Do you own real estate that produces income or could produce income? Would you like to determine an approximate value for the real property?
If yes, the following information will help you arrive at a value based on standard specific information. The information can be applied to a single-family house, duplex, multi-units, commercial properties, land, retail stores, and other income-producing real estate.
Capitalization Rate (Cap Rate)
The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income-producing properties. The cap rate is the net operating income divided by the sales price or value of a property expressed as a percentage. Most Investors, lenders and appraisers use the cap rate to estimate the purchase price for different types of income-producing properties. A market cap rate is determined by evaluating the financial data of similar properties which have recently sold in a specific market. Every market is different.
Cap rate provides a more reliable estimate of value than a market gross rent multiplier (GRM) since the cap rate calculation utilizes more of a property's financial details. The GRM calculation only considers a property's selling price and gross rents. The cap rate calculation incorporates a property's selling price, gross rents, non-rental income, vacancy amount and operating expenses, thus providing a more reliable estimate of value.
Ultimately the seller is trying to sell at the lowest cap rate possible while the buyer is trying to buy at the highest cap rate possible. From the perspective of any investor, the higher the cap rate, the better the investment. Other variables can come into play, such as location, condition, etc., that may not always show up in the Cap rate.
Cap rate is defined as “Net Operating Income” (NOI) divided by Market Value. You can also get the Market Value by dividing NOI / Cap Rate.
A typical example:
- A property has an NOI (Net Operating Income) of $80,000 and an asking price of $1,000,000.
- ($80,000/$1,000,000) x 100= 8% CAP RATE
- A property has a NOI (Net Operating Income) of $80,000 and a Cap rate of 8%.($80,000/.08) = $1,000,000
Gross Rent Multiplier (GRM)
The Gross Rent Multiplier or GRM is a ratio that is used to estimate the value of income-producing property. The GRM provides a rough estimate of value and is much less detailed than using vAP tates but is very helpful in quickly analyzing properties with little information at hand. Only two pieces of financial information are required to calculate the Gross Rent Multiplier for a property, the sales price and the total gross rents. If this information is available for multiple recent sales of similar types of income properties in a particular area, it can then be used to estimate the market value of other similar properties in that area. Some investors use a monthly GRM and some use a yearly GRM. The monthly GRM is equal to the sales price of a property divided by the potential monthly rental income, and the yearly GRM is the sales orice divided by the yearly potential rental income.
The market GRM is only a rough estimate of value and has some limitations such as not taking into account vacancy rates and operating expenses. Remember, when you have enough information to calculate cap rates vs. GRM, utilize the cap rates.
A typical example:
- A property has a sales price of $300,000 and potential monthly rents of $3,500.
- $300,000/$3,500 = 85.71 GRM
- In the same scenario, to calculate the “Estimated Market Value” on an 80 GRM & $3,500 in rents:
- 80 x $3,500 = $280,000 (Estimated Market Value)
Net Operating Income (NOI)
Net operating income is just that, the net operating income of a particular property. It is calculated by taking the yearly gross income less the operating expenses of the particular property. This includes any and all income from the property as well as all operating expenses.
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A typical example:
- Income (Rents & Other) $250,000
- Vacancy Amount: -$5,000
- Operating Expenses: -$175,000
- Net Operating Income $70,000
Simply put, NOI will show you how much money you’ll make after all of your expenses are paid, and all of your rents are collected. This is a great tool for calculating cash flow as well. The NOI is very important in calculating cap rates and debt coverage.
Cash on Cash Return is a percentage that measures the return on cash invested in an income property. It is figured by dividing before-tax cash flow by the amount of cash invested (down payment) and is shown as a percentage (%). If before-tax cash flow for an investment property is equal to $25,000, and our cash invested in the property is $100,000, cash-on-cash return is equal to 25%. Cash-on-cash returns are figured by taking gross income minus vacancy and operating expenses and then subtracting the annual debt service, which will give you before-tax cash flow. Cash on cash return is typically used to evaluate the profitability of income properties and especially when comparing multiple income properties.
A typical example:
- A person invests $25,000 into a property with a before-tax cash flow of $9,000.
- ($9,000/$25,000) X 100 = 36% (cash-on-cash return).
Debt Service Coverage Ratio (DSCR)
The debt coverage ratio (DSCR) is a widely used mark that measures an income-producing property's ability to cover the monthly mortgage payments. The DSCR is calculated by dividing the net operating income (NOI) by a property's annual debt service. Annual debt service equals the annual total of all interest and principal paid for all loans on a property. A debt coverage ratio of less than 1 indicates that the income generated by a property is insufficient to cover the mortgage payments and operating expenses. Most Lenders use DSCR to decide if a property has enough income to cover the debt service. Most Lenders prefer a 1.1 to 1.2 or higher (talk to your local lender to find out). The higher the DSCR is, the more income there is to cover the debt service. This ultimately means less risk to the banks (their point of view).
A typical example:
- A property has an NOI of $50,000 and annual debt service of $36,000
- The DSCR (DCR) would be higher than 1.3. This means that the property generates about 38% more annual net income than would be required to service the annual mortgage payment amount. (See NOI to see how to compute the NOI).
A Number of Factors
I hope the above has been of assistance to you. The true value of any real estate, whether income producing or not, is the value a willing seller will sell for and what a willing buyer will pay. There are many factors that can influence the final purchase price, including:
- the subject property,
- physical condition,
- age of the building,
- personal factors of the buyer and or seller,
- time of year,
- demand factors,
- negotiation skills,
- knowledge of the buyers and sellers,
- investor rate of desired return,
- perceived risks,
- repairs needed, deferred maintenance,
- building code compliance required,
- seller selling options,
- anticipated versus stated income and expenses,
- financing costs, and
- other factors.
All of these will likely come into play in determining a value or agreed selling price.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
Brett B. on August 13, 2020:
Thank you for the helpful and well written article to value income property.