This is something everyone needs to know, whether it be a buyer, seller, investor, or lender.
There are three methods of valuing or appraising a home.
- Comparable Sales Approach
- Cost Approach
- Income Approach
I’ve previously discussed the typical method, and often the only method a real estate agent will ever use – the Comparable Sales Approach. Also known as a CMA (Comparative Market Analysis), this is the method by which we look at what comparable homes are selling (or not selling) and determine what that home would likely sell for.
This method is useful to investors as well when they want to know the value of their home, especially when flipping or wholesaling.
But what about buy-and-holds, or unique investments like apartments or other multi-families that have no real comparable sales?
Or consider – as an investor – who cares what other people are paying for comparable homes? The only amount that you should pay is the amount that makes you money.
Hence the income approach of home appraisal.
The Income Approach.
This is the only method you should be using for commercial properties like apartments, and even other multi-families like fourplexes and duplexes.
There are two main methods of evaluating a property using the Income Approach: Gross Rent Multipliers (GRMs) and Cap Rates.
GRM is Gross Rent Multiplier. GRM is calculated the following: Multiply the annual Gross rents (i.e. not including vacancy or expenses) by the GRM figure that you are targeting.
Value = Gross Annual Rents x Area (or desired) GRM
Ex. A duplex rents for $750/mo per side, $1500/mo total and $18,000/yr. Your investment strategy calls for a GRM of less than 7. $18,000 x 7 = $126,000 value of the duplex.
Or you can work backwards from a purchase price to calculate the GRM by dividing the purchase price by the gross annual rents.
GRM = Proposed Price / Gross Annual Rents
Ex. A fourplex is priced at $195,000 and each unit rents for $595/mo, or $2380/mo total, or $28,560/yr. $195,000 / $28,560 = 6.83 GRM.
GRMs can be used similar to using the comparable sales method, as you can calculate GRMs for the area you are purchasing in, and ensure that your GRM is close to or better than the GRM for the area.
Essentially, a GRM tells you how many years it would be, if you had NO expenses, that a property would recoup its entire value. Remember, with GRMs, a SMALLER # is BETTER. Often under 10 is considered pretty good. Some areas like New York City or San Francisco have GRMs as high as 30 (meaning if you took the rental income of the property, and had NO expenses whatsoever, it would take you 30 years to earn back what you originally put into the property)!
In my experience, this is the more popular method for Income Approach value analysis. Unlike GRMs, you have to have some concept of what your expenses will be. For my quick math, I use the “50% Rule”. Not including the mortgage, expenses will be approximately 50% of a property’s income. Expenses include management fees, maintenance, capital expenditures, vacancy, taxes, and insurance. You can use whatever expense estimate is justified by your business plan. After subtracting these expenses, you have the Net Operating Income (NOI).
Values based of the Cap Rate are calculated as follows:
NOI / Area or Desired Cap Rate = Property Value.
Ex. A duplex rents for $750/mo per side, $1500/mo total and $18,000/yr. Assuming 50% of that $18,000 is expenses, your Net Operating Income is $9000/yr. Your investment strategy calls for a Cap Rate of at least 10%. $9000 / 0.1 = $90,000.
Or you can work backwards from a purchase price to calculate the Cap Rate by dividing the NOI by the proposed property price.
Ex. A fourplex is priced at $195,000 and each unit rents for $595/mo, or $2380/mo total, or a $28,560/yr. 50% of $28,560 is exensese, leaving an NOI of $14,280. $14,280 / $195,000 = 7.32% Cap Rate.
Unlike a GRM, a cap rate is more closely equivalent to your return-on-investment, or ROI. “Good” Cap rates are up to you, but many real estate investors target cap rates between 8% – 15%. Remember, Cap Rates are the opposite of GRMs – a HIGHER # is BETTER.
Have questions about local GRMs or Cap Rates? I’ve got the info! Check out my investor Google Sheet here with local GRMs and Cap Rates. I do my best to be an investor friendly agent and get you comparable sales info and refer leads you can use in your business. Give me a call!
Brian E Adams, REALTOR®, GRI
StarPointe Realty Central Texas LLC
Licensed in the State of Texas