Value Formulas for Real Estate Investors
Wednesday Apr 18th, 2018
Real estate investors use a variety of calculations that can help them make decisions on potential investments. The most common calculations include Capitalization Rate (Cap Rate), Monthly Rental Factor, Gross Income Multiplier and Cash-on-Cash Returns.
CR = Net Operating Income/Property Value
Probably the most widely known. It can be used to find the market value of a property if the market cap rate is known and the property has a solid verifiable income and expense history. It can also be used to compare potential investment properties against each other. The problem with this is that a market cap rate can be difficult to calculate and accurate expense information can be hard to get and verify.
Monthly Rental Factor
MRF = Sale Price / Gross Monthly Income
MRF is a quick and easy multiplier to compare potential investments. For example, if you are looking at 3 properties and you know the asking price and the rental income you can use the MRF to help decide which of the 3 properties would produce the best return. Since this method doesn’t take expenses into account you have to be sure you are comparing apples to apples, that is, the property types have similar expenses.
Gross Income Multiplier
GIM = Sale Price / Gross Annual Income
Similar to MRF but uses annual income instead of monthly. Like the cap rate, the GIM is sometimes used to find the market value of a property if a market GIM is known and the gross income is verifiable.
Cash on Cash Return
COCR = Annual Income / Sale Price
COCR is the inverse of the GIM and is expressed as a percentage rather than a multiplier. COCR doesn’t take expenses into account.
When using any of these calculations you should remember a few points:
- Sale Price should include all the transaction costs of purchasing the property including the price of the property, land transfer tax, legal fees, mortgage insurance fees and any other closing costs.
- When using the MRF, GIM or COCR you are using gross income so you have to be sure that the properties you are comparing have similar expenses. For example, you would not get accurate results if you are comparing a condo townhome with monthly condo fees to a freehold townhome.
- These calculations are best used as a comparison tool. Saying a property has a GIM of 20 or COCR of 5% has little meaning unless you are using it to compare against the GIM or COCR of another property.
- The Net Operating Expenses (NOI) in the Cap Rate calculation should include only those expenses required to operate the property such as property taxes, insurance, leasing commission, property management, etc. It does not include mortgage payments or depreciation expense.
- When using the Cap Rate formula to estimate the market value of a property you have to be very careful that your data is accurate as small difference in net operating income can make a very large difference in value. For example, if the market Cap Rate is 4% and the Net Operating Income of a property is $25,000 then the estimated Market Value is 25,000/4% = $625,000. If the income was off by just $5000 and was $20,000 instead of $25,000 the estimated Market Value would be 20,000/4% = $500,000, a price difference of $125,000.