With all the different methods of evaluating what makes a deal a good deal, it can get pretty confusing at times. There is the Gross Rent Multiplier, Cape Rate, Cash on Cash Return; it tends to get a little confusing which one is the best at evaluation what to choose.
I’m going to do my best to explain the difference between the 3 methods and also explain why we choose to use the Cash on Cash Return method.
Gross Rent Multiplier
First I will start of by explaining what exactly the Gross Rent Multiplier (GRM) is. It is a very simple calculation used to determine if a property is overpriced for the rents it can bring in or if the property is worth investigating further as an investment deal. It isn’t something you would most likely be making a purchasing decision on but it will at least prescreen a deal right from the start. The way you calculate the GRM is by dividing the price that the property sold for by the properties annual income. For example:
Property sold for $250,000 / $21,600 annual income = 11.57 GRM
Is 11.57 a good number you might ask? Well, I guess that depends on which website you come across… I hope you realize I am being sarcastic here.
Some will say the 8 is a good GRM and some will tell you 13 is a good number. Which one is correct? I would say the GRM is not the criteria you want to use. Why not you ask? Well for one it doesn’t include property taxes, property management fees, utilities or any other expenses. If you live in an area with high property taxes that alone could kill a deal you thought was great.
Capitalization Rate or Cap Rate
The most common term you will see when evaluating an investment property is by far going to be Cap Rate. It is used in commercial real estate and also used when evaluating multi-family properties. I can’t tell you how many times I’ve looked at a property on the Multiple Listing Service and asked myself how the hell the agent got that number as their Cap Rate. The Cap Rate is a calculation of the net income divided by price.
I like to use the Cap rate because it takes into consideration all of the expenses such as taxes, vacancy rates, utilities, etc. This will give you a better understanding on what you could expect from your investment as far as a percentage of return goes.
To get the cap rate you take the net income and divide it by the purchase price. We will use the same purchase price and annual income as in our previous example except this time we will include the annual expenses.
($21,600 annual income – $5,350 annual expenses) > $16,250 / $250,000 = .065 or 6.5% Cap Rate
Now you might be asking is 6.5% a good Cap Rate? That decision is going to be based on a few different factors such as your area, the market, and what other investments and opportunity costs you could be missing out on, so that is for you to decide. You will find a lot of properties anywhere from 4% to 10% and obviously the higher the number the better.
Cash on Cash Return
Cash on Cash Return is the method we like to use and this is mainly because it is the calculation of how much money you actually put down vs how much you are getting in net income at the end of the year. If you are paying cash for your property then your cash on cash return will be the same as your CAP Rate. However, if you choose to leverage your money while interest rates are at an all-time low, then you will need to put 20-25% down on a property. So in our previous example, with a $250,000 home we are going to put down only 25% down versus paying cash. Now you only have $62,500 total cash invested in this property. Now we will need to include the mortgage principal and interest into our calculation. There are some good online tools you can use to estimate what the cost will be such as http://www.goodmortgage.com/Calculators/ after including these costs the actual annual income will be around $6,000 for Cash on Cash return of $6,000 / $62,250 = .096 or 9.6%. This is your actual return on your investment. If you were using the CAP Rate for your purchasing decisions you would assume you were getting the same return if you paid cash or financed the deal which is not the case as you can see.
To sum everything up, we recommend you use the Cash on Cash return for analyzing your deals since it is the most accurate way to determine what to expect in return for every dollar you invest.