The investment market can move very quickly. When an attractive property hits the market, it’s common to see multiple offers within just a few days. As an investor, you need to be prepared to evaluate opportunities quickly to decide whether they’re the right fit for you.
Several basic guidelines can help you compare investment properties. Ideally, a comprehensive analysis would consider every factor – rental income, purchase price, upfront costs, appreciation, depreciation, expenses, financing, holding period, time value of money, projected sale price, and tax implications. However, no single method offers a perfect comparison. Each has its strengths and limitations.
Gross Rent Multiplier (GRM)
One of the most commonly used rules of thumb is the Gross Rent Multiplier (GRM), which compares the property’s price to its annual gross rental income. It’s popular because the Multiple Listing Service (MLS) automatically calculates and displays the GRM on each income property listing. In general, the lower the GRM, the better the potential value for the investor. However, its main limitation is that it only takes into account rent and purchase price, without taking into account other important factors like expenses, appreciation, and financing.
Capitalization Rate (Cap Rate)
This rule of thumb is also popular because it’s easy to calculate: simply divide the Net Operating Income (NOI) by the property’s price. The result, known as the capitalization rate or “cap rate,” is also displayed on each MLS listing. In theory, the cap rate is a better measure than the Gross Rent Multiplier (GRM) because it accounts for both income and expenses (NOI = rent minus expenses).
The challenge, however, is that property expenses listed in the MLS are often inaccurate, or even when provided by the owner, may not reflect the true costs. If the expense numbers are wrong, the resulting cap rate is misleading: garbage in, garbage out. To make this measure meaningful, investors need to verify actual expenses or apply realistic estimates for each property analyzed. Like the GRM, though, the cap rate still has limitations, as it only considers rent, expenses, and price, without other key investment factors.
Cash on cash
Cash on cash is one of the easiest to compare directly to a more liquid investment. Simply take the annual cash flow after expenses but before taxes and divide it by the initial investment. The result is a percent return that you can compare to the investment where the cash is sitting before investing in real estate. The drawback is that it only considers rent, expenses, and initial investment out of all the factors listed above.
Debt coverage ratio
When applying for a loan for 5-plus multi-unit properties, most lenders will consider a ratio called the debt coverage ratio. This ratio compares Net Operating Income to the Principal and Interest payment. Lenders will typically want to see a ratio of 1.2. Another way to think about it is that the NOI needs to be 120% of the Principal and Interest payment. Lenders will be using their formula for computing NOI. Variances will be in the estimate for expenses and vacancy allowances.
Internal Rate of Return (IRR)
Probably the best comparison of all, used by the most serious investors, but in general, probably used the least because it is the hardest to calculate. This comparison considers many more of the factors listed above. Still, its accuracy is limited by the accuracy of expense information available, correct mortgage figures, accuracy of prediction of future cash flows (rents and future sales price), accuracy of predicted investor tax bracket at time of sale, etc. Even though the theory behind all of the IRR is great, it’s still just a guess on how the property might perform in the future. The best example of how inaccurate it might be is the appreciation factor. Let’s say in your analysis of past data, the appreciation rate has been 8% a year. Just after you own it, the real estate market slows, and the appreciation rate is 4% per year over the time you own it. The difference between those two numbers significantly affects the IRR. Using IRR provides a great opportunity to put “real numbers” into the formula after you have owned the property for 5 years, sold it, and paid the taxes on it. With those “real numbers,” you can truly compare a real estate investment to other investments that competed for your investment dollar five years ago.
Several products have been developed to help you do an Internal Rate of Return analysis. If you are interested in that, you can go to landlordsoftware.com and check out the various products available.
When you are purchasing investment property, be sure to consult your Realtor, CPA and other investment advisors to make sure the property is right for you.
Duane graduated with a business degree and a major in real estate from the University of Colorado in 1978. He has been a Realtor® in Boulder since that time. He joined RE/MAX of Boulder in 1982 and has facilitated over 3,000 transactions over his career. Duane has been awarded Realtor® Emeritus by the National Association of REALTORS and the Circle of Legends by RE/MAX LLC. Duane is also the author of two books, REALTOR for Life and The Velocity of Wealth. You can reach out to Duane at DuaneDuggan@boulderco.com
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