Posted by Ed Garcia on January 16, 2001 at 23:36:54:
I’m not going to go into a lot of detail, but when you’re purchasing income producing property, you’re buying an income stream. So the income approach will weigh the heaviest.
Methods of Appraising Income Property:
When the primary benefit of real estate ownership is in the form of monthly or annual rent or income, appraisers most often rely on the income (or " capitalization" ) approach as an indication of value. The second method of appraising property based on income, which is known as the “Gross Income Multiplier”. GRM method is commonly used as the income approach in the appraisal of single-family residential properties.
Explaining a Cap Rate:
You take your NOI which stands for (Net Operating Income).
Divide it by the Cap Rate you desire.
This helps you decide the value of the property based on the income.
You have a property that nets you $2500. a month after expenses.
You then multiply $2500. times 12 months = $30,000.
Lets say you want a 8 cap rate.
You then take $30,000. divide it by .08 = 375,000.
At an 8 cap the value of your property is $375,000.
Tom, now here is a more detailed explanation.
Why do you in invest in income-producing real estate? Perhaps you are
looking cash flow. Possibly you anticipate some tax benefits. Almost
certainly, you expect to realize a capital gain, selling the property
at some future time for a profit.
Your projection of the future worth of the property, therefore, can be
a vital element in your investment decision.
A fairly simple approach to this issue is the use of an inflation
rate. You bought the property today for X dollars. You make a
conservative estimate as to the rate of inflation, apply that rate to
your original cost and improvements and come up with presumed future
The use of inflation as a predictor of future value typically makes
sense when the desirability of the subject property is based on
something other than its rental income. For example, consider a
single-user property such as a small retail building on a main
thoroughfare. The owner of a business operating as a tenant in such a
location is probably willing to spend more for the building than an
investor would pay. In general, rate of inflation as a predictor of
future value may be appropriate when comparable sales work well as a
measure of present value (i.e., "Commercial buildings on Main Street
are selling for $200 per square foot by next year they will be up to
With most other types of income-producing real estate, what you paid
for the property is not likely to make much of an impression on a new
buyer. Witness the rapid run-up and even faster collapse of prices in
the late’s. The typical investor will be interested in the income
that the property can generate now and into the future. He or she is
not buying a building so much an income stream.
That investor is most likely to use capitalization of income as the
method of estimating value. You have probably heard this referred to
as a “Cap Rate” method. It assumes that an investment property’s
value bears a direct relation to the property’s ability to throw off
Mathematically, a property’s simple capitalization rate is the ratio
between its net operating income (NOI) and its present value:
Cap. Rate =NOI/Present Value
Net operating income is the gross scheduled income less vacancy and
credit loss and less operating expenses. Mortgage payments and
depreciation are not considered operating expenses, so the NOI is
essentially the net income that you might realize if you bought the
property for all cash. If you purchase a property for $100,000 and
have a NOI of $10,000, then your simple capitalization rate is 10%.
To use capitalization to predict value requires just a transposition
of the formula:
Present Value =NOI/Cap. Rate
The projected value in any given year (i.e., the “present value” in
that year) is equal to the expected NOI divided by the investor’s
required capitalization rate.
To use capitalization rate as a predictor of future value, in short,
is to use this logic: "I am buying this property with the expectation
that its net operating income will represent a return on my
investment. It is reasonable to assume that whoever buys the property
from me in the future will have a similar expectation. That new
investor will probably be willing to purchase the property at a price
that allows it to yield his or her desired rate of return (i.e.,
If you project that the property will yield a NOI of $27,000, and that
a new buyer will require a 9% rate of return (capitalization rate),
then you will estimate a resale price of $300,000.
You must never forget that, while the algebra involved here is simple,
the judgments you need to make in order to achieve an accurate
prediction of value are more complex. Your assumptions as to future
years’ income and expenses have to be realistic.
The same is true of your estimate of a new buyer’s required cap
rate. Look at the investment from the new buyer’s point of view and
remember that there are other opportunities competing for his dollar.
Would you buy an office building with a projected cap rate of 9% if
you could buy a bond that yields 8%? What if mutual funds are rocking
and rolling at 15% and more? To attract a buyer, your property may
need to be priced so that its cap rate is competitive. The higher the
cap rate, the lower the price. In our example above, the property with
the $27,000 NOI capitalized at 12% would be worth only $225,000.
Our discussion here has been limited to simple capitalization rates.
If you would like to delve deeper into this topic (for example,
mortgage-equity cap rates), an appraiser’s text on income-property
valuation should be your next step.
Explaining Gross Rent Multiplier:
Value is the present worth of all rights to future benefits. The right being obtained through the payments of rents are the use of the physical structure as well as the intangibles ( amenities or satisfaction). Income properties such as large apartments and commercial stores are purchased for the income stream they produce, whereas single-family homes are purchased for shelter plus the satisfaction ( amenities of home ownership).Standard capitalization techniques used for income producing properties do not measure intangibles such as pride of ownership and other amenities found in home ownership.
The indirect method of capitalization or gross rental multiple will measure the market value of the combination on intangibles and tangibles found in single family and small income properties.
Gross Rent Multiplier (GRM) by comparing actual rentals and sales prices of properties
Comparable to the subject, to get another indication of value by multiplying the monthly
rent by an appropriate GRM. If a comparable property rents for $700 a month and sells
for $84,000 which is 120 times the gross monthly rental ($84,000 divided by $700=120),
then the indicated |GRM applicable to the subject property is 120, plus or minus adjustments for deficiencies in or greater benefits from the subject property. GRM is the ratio between rental income of a property and it’s sale price.
Method of approach in using the Gross Rent Multiplier
A. Determine the fair or economic rent of the subject being a appraised by comparison
with similar rental properties.
B. the gross rent multipliers of the sales one investigates are calculated by dividing the
sales price by the monthly rents.
C. The rent multipliers may then be tabulated showing how these properties varied
From the subject-better or poorer.
D. The rent multipliers are not averaged to arrive at one final multiplier,
Each property and it’s multiplier is compared to the subject as to the fair
rent obtainable, location of property, size, condition, and utility of the
house, and the amenities to be desired.
After proper analysis, one rent multiplier should be obtained.
E. The gross rent multiplier selected, multiplied by the fair rental of the subject property
Results in the value estimate by means of the Income Approach.
Lenders and appraiser may calculate a GRM by using annual rents instead of monthly.
For example: the gross income from an unfurnished apartment building is $200,000 per annum. If an appraiser uses a gross multiplier of 7% then it is said that based on the gross multiplier the Value of the building is $1,400,000.
Hope this helps,