Basic Valuation Methods for Phoenix Income Properties.

By sonoran • August 12th, 2008

Three simple ways to analyze Phoenix real estate investments; the pros and cons.

There are many ways to analyze a real estate investment purchase;  besides investigating location, demographics and timing an investor will also come across the Gross Rent Multiplier, the Cap rate and Cash on Cash, as indicators of investment performance.  Many brochures from sellers and agents will contain these numbers.  Below is an overview of what these are and their pros and cons.

GRM (Gross Rent Multiplier)

This method calculates the value of the property using gross rents that are expected in the investment or projected rental income (PRI)
GRM x Forecast 1st year PRI = Value

For instance:  A property that has a forecasted first year income of $40,000 and the investors desired GRM is 9 then the value is $360,000.  Similarly if a property is on the market at $250,000 and it has a PRI of $19,000 then the GRM is 13.

 
Pros and Cons of the GRM.
The main advantage of the gross rent multiplier is its simplicity.  This simplicity is also its fault.  The GRM does not consider vacancy or credit losses, operating expenses, financing and tax consequences.  In addition, it only looks at one year of income when determining value

CAP Rate (Direct Capitalization)


The cap rate uses the income stream to determine value.


The cap rate is calculated by dividing the Net operating income(NOI) by the price.
NOI/Price=Cap Rate.


Similarly if you have a desired cap rate or you know what the market cap rate is you can divide the NOI by the cap rate to arrive at the price.  So if a property has $30,000 NOI and the market cap rate is 10 then $30,000/.10 or 10% = $300,000. 

What’s your desired cap rate?

Pros and Cons of Cap Rate:
The cap rate brings operating expenses into establishing the value.  Its simple to calculate. 

It does not allow for investment factors such as appreciation or depreciation, financial leverage and amortization, income taxes, nor risk.

 
Cash on Cash


Cash on cash is another method to determine performance.  It’s calculated using the first year cash flow before taxes, using only the investors initial outlay or investment. 

Calculate cash on cash by dividing the first-year cash flow before taxes by the initial investment (down payment) to arrive at cash on cash or yield.

Cash on cash is often used to calculate the length of time required to return the initial investment to the investor.  Cash on Cash can be compared to the dividend on a stock, the interest payment on a bond.


Pros and Cons of Cash on Cash:
It’s easy to use, many investors are cash oriented.  It takes into account credit losses, operating expenses and financing.  It does not allow for other relevant investment factors such as appreciation, income taxes, mortgage amortization or risk. Its also difficult to use it to meaningfully measure performance between investments.

Each of these three quick analysis methods, the GRM, CAP Rate, and Cash on Cash are a good start as a preview for further analysis; investors should be careful not to overly put too much weight into these measures to either accept or disregard an investment property. 

In a future post we will cover more in depth measures such as the IRR (Internal rate of return) and Capital Accumulation.  Both of these will give an investor a more in depth view of their investment.

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