Understanding Cap Rates and Multipliers
So… you’re ready to invest, huh? You’ve been reading the Monday Morning Memo and you think you’ve got it all figured out. Then you read a real estate listing touting a great investment opportunity with a “Cap Rate of 6%”, or a “13 GIM” … and suddenly you’re not so sure.
What are Cap Rates? And what are Income Multipliers? In this brief article I’ll outline two of the most common rules of thumb used by Realtors and investors alike in describing investment property.
(1) Capitalization Rates. Or cap rates, for short, are imaginary numbers that are used to define return on investment in apples-to-apples terms, allowing for easy comparison of various investment opportunities.
A cap rate is arrived at by completing the following equation with respect to a given property:
Cap Rate = Net Operating Income / Purchase Price
So if you know that a property makes $80,000/year in net income (after expenses, but before debt service), and costs $1,000,000, then you can quickly arrive at a cap rate of 0.08 or 8% for this property. You can see that this makes sense, since investing your one million in cash would net you proceeds of 8% or $80,000 annually.
Cap rates are great because once you know what rates can be expected for a given type of property or market, then you can begin to understand value. If the above million-dollar property were typical of our market, and then we came upon a $500,000 property that netted $60,000/year, we would instantly know that this was a great deal (all other things being equal), since its 12% cap rate was well above the market norm. We could surmise that this property was actually worth $750,000 as an investment, based on these income numbers and the prevailing 8% rate. What a bargain at half a million!
(2) Gross Income Multipliers. These are used to asses the value of income assets as well, and are sort of like an inverse relative of cap rates (the Net Income Multiplier is the true inverse of a cap rate). They are arrived at through the following equation:
GIM = Purchase Price / Gross Income
So let’s say our $500,000 property above grossed $75,000/year before expenses. That would indicate a GIM of around 6.67 for this property. In general, a lower GIM is better because it means that it will take a shorter period of time (in this case 6.67 years) to recoup the entire investment in gross revenues. Amazing!
With GIMs and cap rates mastered, you’ll be well on your way to quickly analyzing investment opportunities and moving on to further stages of due diligence on only those that meet your rate or multiple requirements first. It’s a great way to sort through the market and find good potential, fast.
Tell your friends! They’ll thank you. Call me if you’re interested in learning more about buying or selling real estate.
Until next time,
Shaun Nilsson
1-888-712-7888
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