When analyzing real estate investments, it is important to understand the four commonly used metrics for measuring value and performance:
GRM: Gross Rent Multiplier. This metric has drawbacks for larger properties.
Cap Rate: Capitalization rate.
IRR: Internal Rate of Return.
ROE: Return on Equity, also known as cash on cash.
The most universally applied valuation metric for investment real estate is the cap rate. In its simplest form, the cap rate is defined as the overall rate of return a property produces in a year unleveraged (that is, unencumbered with a loan).
From an appraiser’s standpoint, the cap rate is ideally derived from sales comparables in the marketplace of the subject property. One must compare the rate at which properties of a similar class, condition, age, NOI stability, and credit-worthiness of the tenant are selling in a particular marketplace. For instance, the cap rate for a 30-year-old, 150-unit apartment project in Topeka may be significantly different than a similar size and age property in Washington, D.C.
Using this formula, an investment property with an NOI of $85,000 and an applicable investor cap rate of 8.5% would have a value of $1,000,000.
While simple on the surface, there are two main elements: NOI and Cap Rate. These have to be reached methodically, accurately and with great market knowledge. The buyer’s and seller’s opinion of the NOI for the same property could be the same, or they could differ dramatically.
Another way to look at how this formula works would be to view it as follows: an investor purchased a property for $1,000,000 in cash (Equity Investment). At the end of one year his profit or Net Operating Income (NOI) was $85,000. The investor would have earned an 8.5% return on his investment.
The key to establishing the legitimate investment value of an income producing property is to ensure you are dealing with an accurate operating statement and a realistic cap rate.