There are 3 basic methods for analyzing rental properties or income producing commercial properties: income approach, cost approach, and sales comparison approach
Each approach can be effective depending on whether you’re trying to figure out future income and expenses, reproduction costs, or how you compare to the market.
The sales comparison approach can be useful if there are numerous comparable properties. Residential properties are typically in this situation but there a not too many comparable commercial properties. This approach tries find similar properties that have sold recently and really more suitable for the analysis of a residential rental property versus a shopping center or office building.
The cost approach can be effective for analysis of special purpose properties or new construction and situations where separate values are needed for the land and building. It can also be useful when there are few comparable properties to compare with and compares the subject property to a new duplicate of itself to determine the reproduction or replacement cost. So this approach is more effective for newer properties and less effective for older ones. Typically, accountants and insurance companies use this approach to analyze properties but not by investors analyzing the purchase of a property.
On the other hand, the income approach analyzes the capitalization of income commonly referred to as the cap rate and best suited for analyzing income producing properties such as rental homes, shopping centers, warehouses, office buildings, etc.. To determine a property’s value, the process involves the use of rates (i.e. cap rates) to capitalize the property’s single-year net operating income (NOI) into a value estimate. The formula is: Value=Net Operating Income / Capitalization Rate. If the NOI is $100,000 per year (before debt service and depreciation) and the cap rate is 10 percent, then the value would be $1,000,000. ($100,000/0.10). An overall capitalization (cap) rate is defined by net operating income (NOI), (before capital items of tenant improvements and leasing commissions and debt service but after real estate taxes) divided by the value.
There is an inverse relationship between the sales price and the cap rate. The lower the sales price the higher the cap rate. The higher the sales price the lower the cap rate. If you’re a real estate investor, the higher the cap rate, the better the investment. Remember that even a 1 percent difference in the suggested cap rate could make a significant difference in the value estimate.
Investors typically value a property based on property’s Potential Gross Income (PGI). 2 ways to analyze potential income are Gross Income Multiplier (GIM) analysis and Gross Rent Multiplier (GRM) analysis. The PGI is the maximum income a property produces with 100%. The GIM analysis is the ratio between the property’s gross annual income and its selling price. If a property earns an annual gross income of $50,000 and sells for $450,000, then it has sold at a GIM of 9 or in other words 9 times its gross income. The GRM analysis is the ratio between the property’s gross monthly rental income and the sales price of the property and only refers to the rent whereas the GIM includes all the income generated by a property. The GIM and GRM multipliers are direct reciprocals of the cap rate.
To analyze a property’s estimated future revenues and expenses, you need to create an Operating Statement. To do so, the formula is as follows:
Potential Gross Income (PGI)
minus Vacancies & Collections
plus Other Income (e.g. billboard)
equal Effective Gross Income (EGI)
minus Operating Expenses (3 types: fixed, variable, reserves)
equals Net Operating Income (NOI)
minus Annual Debt Service (e.g. mortgage payments)
equals Before Tax Cash Flow (BTCF)
equals After Tax Cash Flow (ATCF)
From this simple statement, you can determine a number of things about a property. You can figure out the occupancy level to break even by adding the reserves and annual debt service, subtracting operating expenses, and then dividing by the PGI. If you subtract this ratio from one, it will let you know the percentage of vacancies you can have. You can also figure out your return on investment or down payment by dividing the BTCF by the down payment. There’s much more you can infer from reconstructing an operating statement and it will allow you to delve much more deeply into the investment value of a particular property.
You need to study every facet of this statement to ensure that the property is operating on a stable basis. You also need to ask yourself if the rents are at level with the market, are occupancies at optimal levels, and are expenses being managed properly. Anyone considering an investment in the 6 and 7 figure range should understand these concepts before jumping in. Perhaps some of the speculators that are stuck with residential properties in this market would not have bought if they understood these aspects of investment analysis. They would have understood that the market rent would not allow them to come close covering their expenses.
Anyway, there you have it. It seems complicated at first but it’s all just basic arithmetic. All you have to do is plug in the numbers. It’ll definitely provide a much clearer picture of a property’s investment value. It’s highly recommend you grasp this before investing in real estate unless you just like to gamble.