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You may be familiar with the gross rent multiplier. This simple formula for determining the value of rental real estate has been around for ages. The first book I read on investing in real estate advised me to "never buy a property with a GRM of more than 8." GRM is the acronym for gross rent multiplier, of course, and the formula is this: divide the price by the gross annual rents to get the GRM.

In other words, the author was advising me to never pay more than 8 times the annual rent for a rental property. That seemed simple enough. I started looking at properties in terms of GRMs. If it was selling for 6 times rent it must be a good deal. If it was 12 times rent it had to be bad. It was great to have such a simple rule to follow - except that it never was a good rule to begin with.

Using a gross rent multiplier is a crude way to put a value on a property. It is just too simplistic. Suppose two buildings each are selling for eight times their gross annual rent collections. One however, includes all utilities in the rent that tenants pay. That changes things, doesn't it? Of course, you could try to subtract out the utilities, to see what rents would be if they weren't included, and use that for the GRM. But that's not the only problem.

You need to constantly change the GRM expectations to reflect interest rates, because a property might be profitable at 12 times rent when interest rates are low, but a money loser at eight times rent if the financing is expensive. Also, there are just plain different expenses for different properties, whether higher maintenance costs, insurance premiums, or whatever. Gross rent doesn't say much about the factor that really makes a rental property valuable: the net income.

Valuation Using Cap Rates

You buy rental properties for the income they produce, right? Then this is what your real estate valuation should be based on. That is why you need to how to use a capitalization rate, or "cap rate" to determine value. A cap rate is the rate of return expected, or the rate of return on a property at a given price.

An example will make this clear. Start with the gross income of a property and subtract all expenses, but not loan payments. Suppose the gross income is $80,000 per year, and the expenses are $34,000, you have net income before debt-service of $46,000. To arrive at an estimate of value, apply the capitalization rate to this figure.

Let's suppose the normal capitalization rate is .10 in your area, meaning investors expect a 10% return on the value of their investment. You can use your own rate, of course, but if others are paying more you may have a tough time buying anything. Now divide the net income of $46,000 by .10, and you get $460,000 - the estimated value of the building. With a cap rate of .08, meaning an 8% return, the value would be $575,000.

Looked at the other way around, to see what the cap rate is based on the asking price of a property, just divide the net income by the asking price. For example, if a seller wants $675,000 for a property, and the net income is $55,000 you would divide 55,000 by 675,000. This gives you a cap rate of .81.

Value equals net income before debt-service divided by cap rate. This is a simple formula, but the tough part is getting accurate income figures. Be sure the seller gives you Cap">ALL the normal expenses, and doesn't exaggerate income. Suppose he stopped repairing things for a year, and is showed "projected" rents, instead of actual rents collected. The income figure could be $15,000 too high, which would cause you to estimate the value at $187,000 more (.08 cap rate). Ouch!

Smart investors sometimes separate out income from vending machines and laundry machines. If these sources provide $6,000 of the income, that would normally add $75,000 to the appraised value (.08 cap rate). However, you can do the appraisal without including this income, and then add back the replacement cost of the machines, which is probably much less than $75,000.

Of course if you are competing to buy properties based on the same cap rate used by others, but you have to borrow at higher interest rates or buy with less of a down payment, you could have cash flow problems. Don't let formulas get in the way of thinking through all the factors. No simple valuation formula is perfect, and all are only as good as the figures you plug into them, but using cap rates is certainly better than using gross rent multipliers.