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3 Ways to Analyze an Investment
1. Gross Rent Multiplier (GRM): The price of the real estate divided by the gross income including the rent and all possible sources of income such as coin operated laundry machines or cellular tower fees.
GRM is derived from comparable properties in the marketplace and may be adjusted to reflect the investor’s specific requirements.
Formula: Sales Price / Annual Gross Income =
Gross Rent Multiplier
Example: Lena, an Investor receives information on a 10,000 square foot strip center which generates an average of monthly income of $1.58 per square foot for a total of $15,800. After Lena annualizes this figure to $189,600, she divides the gross income into the asking price of $2,085,600 for a GRM of 11.
This is the most simplistic approach and often used to quickly evaluate multi-family properties. A higher GRM achieved is better for the Seller.
The biggest disadvantage of only using the GRM approach to investment analysis is that it fails to consider the effects of vacancy and credit losses, operating expenses, and financing. Also, it looks only at a one-year forecast when determining value.
2. Direct Capitalization Rate: Direct capitalization is a process of converting a future income stream into a present value (PV) by dividing a future income amount by a “cap rate.”
Formula: R = I/V Where: V = Investment Value
I = First Year NOI
R = Cap Rate
Or: V = I/R
NOI (Net Operating Income) is defined as: Projected Rental Income + other sources of income generated by the property (e.g. coin-op laundry) minus vacancy, credit losses, and operating expenses.
Example: Commercial Broker, Kevin sends his clients, Brian & David, information on a single tenant office building made up of 6,868 square feet of rentable space. The property has four years remaining on the lease for an effective rate of $2.25 per square foot on a modified gross basis per month for a total of $15,453, or $185,436 per year. The Seller’s recurring operating expenses including property taxes, insurance, common area maintenance and management fees are $63,048 annually. What’s left before the mortgage and income tax is $122,388 otherwise known as the net operating income (NOI). Since the asking price is $1,750,000, the “cap” rate is 6.99%. Because Brian & David feel that the property is in a "B" market with lower demand for such space, they believe that the property should be earn them a 7.5% capitalization rate. As a result, Brian and David reverse the procedure and divide the NOI into the desired cap rate for what they are willing to pay. In this case, the Kevin submits an offer on behalf of Brian & David for $1,631,840.
The direct capitalization approach is superior to GRM because it does account for property taxes, insurance and other operating expenses. However, it does not account for debt servicing (mortgage payments), one-time capital repairs/improvements or the impact of income tax. It also only looks at a one-year “snapshot” of the property’s performance.
3. Cash-On-Cash Return: Cash-on-Cash is another approach to determine investment value or measure investment performance. It goes further than the Cap Rate approach because it does take into account debt servicing, one-time expenses. However, it also only looks at a one-year “snapshot” of the property’s performance.
A. Determining Value:
First-year cash flow before taxes (CFBT) /Cash on cash (yield) = Initial Investment.
Initial Investment + Loan Amount = Value
B. Measuring Investment Performance:
First-year CFBT/Initial Investment (i.e. hard cash invested) = Cash-on cash yield
Example: Doug, an Investor committed $100,000 in a 30% down payment for a 1,667 square foot retail building in the heart of Old Town Monrovia. He also had to pay Hal, the roofing contractor $5,000 and come up with $7,000 in escrow closing costs. His out-of-pocket for the deal is $112,000. Because the property generates $20,460 per year after the annual net expenses and mortgage are taken into account, Doug’s before-tax Cash-On-Cash return is 18.27%.
The Cash-On-Cash method goes further than the Cap Rate approach because it does take into account debt servicing. However, it also only looks at a one-year forecast when determining value or measuring performance.
Some investors may require more comprehensive methods of valuing property and/or measuring performance which include extensive forecasting and analysis. These methods include discounted cash flow approaches such as Internal Rate of Return (IRR), Net Present Value (NPV), and Capital Accumulation Comparison.
For a further discussion of these approaches to performance and value, you are welcome to contact us.
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