Investors rely on three tools, at different levels, to discern whether or not something is a good investment. Today I’ll detail what those tools are and how they’re used.
1. Gross rent multiplier. Whether for an individual home, duplex, triplex, or apartment, the gross rent multiplier is a basic mathematical equation that gauges value. To calculate it, you take the value of the home and divide it by the annual rent. The higher your quotient, the better. On the subject of rent-to-property-value ratio, this segues well into “the 1% rule.” This rule holds that the monthly rent coming in should be worth 1% of your purchase price.
2. Cap rate. Investors with institutional investments such as apartment buildings, office buildings, or strip malls are most familiar with this. Calculating the cap rate will help you determine how the building is performing without taking financing into account. Here, you subtract total monthly expenses (utilities, property management, property taxes, etc.) from your total monthly rent, and multiply what’s left over by 12 to represent months of the year. From there, you divide that figure by the value of the building. This will give you your cap rate.
3. Cash-on-cash return. Individual investors are known to go off of this last measure. How this works is you subtract your mortgage payments from your net rent (refer back to cap rate). Once your mortgage has been subtracted, you’re left with the cash flow you’re bringing in. And, rather than dividing by building value, you divide by equity. The idea here is to measure how much cash you’re generating against how much you’re putting in.
If you have further questions about any of the investment valuation tools I covered or for help with anything else investment related, please reach out and give me a call today.