# The GRM does not include expenses such as property tax, insurance, operating costs, and vacancies.

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1 Common Real Estate Investment Formulas I. Introduction Many agents represent clients who are investors. These investor clients can vary from first time investors buying their first rental property to very sophisticated and experienced real estate investors. Investors will often utilize or discuss certain mathematical formulas to help assess the investment potential of a property. It is important for agents to be able to understand these formulas in their practice. We will review some of the more common formulas investors utilize and discuss what is being calculated and what the utility of the formula is for investors. II. Gross Rent Multiplier Q 1. What is the gross rent multiplier? A The gross rent multiplier ( GRM ) is a commonly used method of evaluating a commercial real estate investment by calculating the number of years it would take for the annual gross rent received for the property to equal the price paid for the property. The resulting number can be used as a tool for investors to quickly survey the properties in a particular market in order to identify which properties are priced lowest in correlation to the market based gross potential income. The lower the gross rent multiplier the higher the rate of return on an investor s initial investment. Q 2. How is the gross rent multiplier Calculated? A The GRM is calculated by dividing the price of the subject commercial property by the projected annual gross income. The GRM does not include expenses such as property tax, insurance, operating costs, and vacancies. To illustrate the GRM, let s consider our commercial property priced at \$729,000 where the gross rental income for the whole of 2015 is projected to be \$53,100. In this case, the GRM, taken by dividing \$729,000 by \$53,100, would be x rents. This means that, at this gross income, it would take years for the investor to recoup the purchase price of his investment. Remember, the lower the GRM, the more gross rental income the investor will receive for each dollar invested. Gross Rent Multiplier = Price Potential Annual Gross Income = \$729,000 \$53,100

2 Q 3. What is a good gross rent multiplier? A There is no general answer to this question because average GRMs will normally vary with respect to both marketplace and the type of commercial property. For example, the average GRM of apartment buildings in Costa Mesa last year might have been 16 x rents while that of similar properties in Anaheim were 13 x rents. For this reason, the GRM is best used as a comparative tool for evaluating multiple properties of the same kind in the same geographical or trade area. Q 4. When should you use the gross rent multiplier? A The GRM requires very little information to calculate and it provides a quick and easy tool to evaluate comparable properties within the same market area. Comparable properties should have approximately the same gross rent multipliers. If the subject property does not, the property may require additional investigation to evaluate the reason for the discrepancy. As the GRM does not take into account taxes, operating costs, insurance or vacancy rates it does not give the investor a complete and accurate projection of the potential return on a particular investment., However, it is a concept that can be easily understood by investors. Consequently, it may be a good place for investors and agents to start in locating a sound investment. III. Capitalization Rate Q 5. What is a capitalization rate? A The capitalization rate (or cap rate ) calculation is another popular formula used in valuing commercial real estate. It is a measure of return on a commercial property based on its projected net operating income ( NOI ) for the first year of ownership. This method of evaluating commercial property is more complete and accurate than the GRM because it takes into consideration taxes, potential vacancy, insurance and other operating costs for the investor. However, this calculation is intended to show an investor s annual return on an all cash investment and does not take into consideration any interest on a loan if the seller obtains financing for the property. Q 6. How is a cap rate calculated? For the purposes of this calculation, annual net operating income is the total annual gross rental income less property taxes, vacancy rate, insurance and other operating expenses. These variables will generally vary between properties. A Cap rates are calculated as follows: Capitalization Rate = annual net operating income cost (or value) 5.34% = \$38,958 \$729,000

3 Q 7. When should I use a cap rate? A Similar to the GRM, the cap rate is best used as a tool to compare like-in-kind properties in the same marketplace at the same period in time. Therefore, this calculation should be used by investors and agents to ascertain 1) approximately the amount of annual income they should expect to receive from a particular investment and 2) how one potential commercial real property investment may compare to other similar, available properties in the same marketplace. Also, in the event that an agent has a client looking to sell a commercial property, the cap rate can be used as an effective tool to help establish a listing price. For example, if your client would like to sell an apartment building with an NOI of \$38,958, you may want to show the investor the value of the property at a 5% cap, a 6% cap and a 7% cap (assuming this was the average range of cap rates for other similar buildings sold recently in the same marketplace) in order to help the seller determine a listing price. You would then calculate this price as follows: Price = Net Operating Income Capitalization Rate \$729,000 = \$38,958 (NOI) 5.34% (CAP) Again, for the purposes of these calculations, there is no general right cap rate. Instead, you should look at the cap rates of recently sold or listed comparable properties as well as the goals of the particular client when deciding on an appropriate listing price. Q 8. What are the negative aspects of using cap rates? A As mentioned above, one of the more prominent weak points of using cap rates to determine the value of commercial real estate is that they do not take into consideration the economic impact that financing will have on the investment. Additionally, commercial real estate investors often seek properties with the potential for future up-side. This is often referred to as value-add. One of the most common ways for investors to do this is to buy into a commercial property with below market rents (preferably expiring in the near future) and later raising those rents for a boost in NOI. Due to the fact that cap rates generally consider only the NOI produced in the first year of ownership, you may miss a potential value-add opportunity if you solely consider the cap rate without further due diligence. Refer to the Pro Forma rents and the cap rate of 5.70% versus that of the cap rate for Actual Rents yielding a cap rate of 5.34%. Cash on Cash Return The cash on cash return measures the first year cash return against the cash invested at the beginning of the year. The advantage of the cash on cash return is that it takes into account vacancy, credit losses, other income, operating expenses, AND debt financing (unlike the cap rate). It also is a simple formula that does not require projecting out cash flow over multiple years. The negative aspect of using the cash on cash return is that it only takes into account one year of operating data.

4 Cash on Cash Return = Net Annual Income IV. Price Per Square Foot Comparables Total Cash Invested (does not include financing) Q 9. Can you value commercial real property by using price per square foot comparables? A In residential real estate, agents often use price per square foot comparables in determining a reasonable price for a property. In commercial real estate, price per square is often used in addition to cap rates and other calculations of value when comparing like-kind properties in the same market place. The price per square foot of a property is taken by dividing the total price of the property by the amount of gross square feet that make up the structure on the property. For example, if a 3,332 square foot building is offered at \$729,000, its respective price per square foot is \$ (729,000/3,3332 = ). Price Per Square Foot = Purchase Price Building S. F. \$ = \$729,000 3,332 However, this calculation does not take into consideration the amount of units or quality of the complex in each property and thus can be an inaccurate representation of investor value when evaluating apartment buildings or other multi-family investment properties. Generally, monthly rental prices for apartment units are not calculated as a measure of price per square foot, but instead by taking into account the amount of bedrooms, building amenities, and quality. Consequently it is not uncommon for one apartment unit to rent for the same amount (or even more) than another unit in a different complex in the same area; even if it is smaller. As a result, two apartment buildings that have the same total livable square footage and are located in the same marketplace (or even on the same street) may produce different NOI s and will have different values for potential investors. V. Price Per Unit Comparables Q 10. Can I value apartment buildings and other multi-family properties by using price per unit comparables? A This method of commercial property valuation is generally used exclusively for multi-family properties. An apartment building s price per unit is taken by dividing the total price of the property by the amount of units in that building. For example, a 3-unit apartment building being listed at \$729,000 has a price per unit of \$243,000 (729,000/3 = 243,000). Price Per Unit = Purchase Price Number of Units \$243,000 = \$729,000 3

5 Similar to using price per square foot comparables, price per unit comps can be a useful tool when combined with more precise calculations or to quickly filter investment opportunities in a given marketplace. However, due to the fact that this measurement does not consider operating costs or net income, it should be used by neither agents nor investors as a sole means of determining the soundness of a potential investment opportunity. Loan to Value The loan to value ratio (LTV) is simply the ratio of the loan amount to the value of the property. This is a critical constraint banks face when financing a property, and ultimately the value side of the equation is typically restricted by a third party appraisal. Loan to Value (LTV) = Loan Amount Lower of Purchase Price or Appraised Value Debt Service Coverage Ratio The debt service coverage ratio (DSCR) is expressed as net operating income (NOI) divided by total annual debt service. This is another critical constraint banks face when financing a property. Typically both the loan to value ratio and the debt service coverage ratio will be determined by a bank s loan policy. These are both important formulas to know because a loan amount will almost always be limited by the lesser of the two constraints. In other words, the maximum loan amount will be limited by either LTV or DSCR. DSCR = Net Operating Income / Total Debt Service In personal finance, it is a ratio used by bank loan officers in determining income property loans. This ratio should ideally be over 1. That would mean the property is generating enough income to pay its debt obligations. A DSCR of less than 1 would mean a negative cash flow. A DSCR of less than 1, say.95, would mean that there is only enough net operating income to cover 95% of annual debt payments. For example, in the context of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat. Generally, lenders frown on a negative cash flow, but some allow it if the borrower has strong outside income. Operating Expense Ratio The operating expense ratio is simply the total operating expenses divided by effective gross income (EGI) or gross operating income. This ratio is a useful measure that shows you what percentage of income is consumed by operating expenses. Looking at operating expense ratio trends over time in a multi-year analysis can sometimes reveal important trends. The operating expense ratio is a useful tool when comparing the expenses of similar properties. If a particular piece of property has a much higher OER for a particular expense, such as maintenance, an investor should see that as a red flag and should look deeper into why maintenance expenses are so much higher than comparable properties.

6 Net Operating Expense Ratio = Net Operating Expenses Gross Scheduled Income 23.63% = \$ 12,549 53,100

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