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Does Cap Rate or GRM Best Estimate a Rental Property's Value?

By James Kobzeff

Republish: EasyPublish™ Published: 22Sep2009 Word count: 771 Viewed: 362 time(s) Get Free Content For Your Site

Cap rate and GRM (gross rent multiplier) are popular real estate investing measures regularly used by real estate agents and individual investors seeking to determine whether a rental property is, or is not, priced correctly and maybe might be a good investment opportunity.

Both measures only provide an estimate of rental property value, and alone neither provide a true picture of a property's profitability. But they can provide a quick first-glance look at a property's ability to pay its own way and because they are easy to compute, they are a popular way to determine whether a property is in line with similar, other recently sold or listed rental properties.

As a result, cap rate and GRM are used by sellers to set a selling price for rental properties, and by buyers trying to determine what price to offer.

So which is better? At the end of the day, which method of estimating a rental property's value best measures the property's financial performance and therein promotes a smarter investment decision?

In this article, we'll consider both, and then decide.

Capitalization Rate

Cap rate measures the relationship between a property's net operating income and its price by expressing the 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. Net operating income (NOI) represents all income less operating expenses thereby indicating the amount of money produced by the property available to pay the mortgage (this is why lenders look closely at the property's net operating income when making a loan). In this case, cap rate reveals what percent of sale price these available funds are.

The formula is straightforward. To estimate a rental property's value, multiply the property's NOI by whatever capitalization rate you deem appropriate. For example, if similar properties are selling at a 6.0% cap rate and you deem that suitable, multiply the subject property's net operating income by 6.0 to arrive at its market value.

The disadvantage of this method is that it's sometimes difficult to confirm a sold property's actual operating expenses and therefore difficult to determine the actual (not merely the published) rate it sold for.

There is no such thing as a universal cap rate. It depends on individual market areas, what might make one rental income property look like a steal in one city or state at 6%, might not get a second look in another.

Gross Rent Multiplier

The GRM method (expressed as a number) measures the ratio between a rental property's gross scheduled income (GSI) and its price.

Its advantage is that it 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. Divide a property's selling price by its GSI to arrive at a gross rent multiplier, and multiply a property's GSI by whatever GRM you deem appropriate to arrive at an estimate of the property's value.

For example, if similar rental properties have recently been selling at a 5.0 GRM and you want to estimate the market value for a specific property with a gross scheduled income of $200,000, you would multiply that amount by 5.0 to determine its value.

The disadvantage of this method is that it ignores occupancy levels and operating expenses, both of which are important indicators regarding the overall performance of a rental property and required for sound real estate investing decision-making.

Here again, GRM is market-driven so there is no universally correct number. I would be surprised, however, to see a number lower than 4.0 or higher than 12.0 and if so, strongly recommend that you dig deeper into the numbers that produced those results. Okay, so which method is the best way to determine 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.

Naturally, 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, numbers can be manipulated. When told how great a buy an income property is based upon its cap rate, be sure to reconstruct your own raw data to insure that all is revealed and nothing is concealed before you actively pursue the real estate investment further.

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