In commercial real estate, the most commonly used calculation for ROI is called the Capitalization Rate (CAP rate). Combine the CAP rate and the GRM together, and you should have a pretty good idea of where the property will sell. An experienced real estate agent can help with the detailed analysis.
CAP Rate = Net Operating Income divided by the Property Asset Value
For example, A commercial property sells for $1,000,000 and generates an annual Net Operating Income (NOI) of $100,000, the Cap Rate would be 10%.
1. Income ÷ Rate = Value
2. Income ÷ Value = Rate
3. Value x Rate = Income
Net Operating Income ÷ Capitalization Rate = Value
$100,000 income ÷ 9% cap rate = $1,111,111
$100,000 income ÷ 8% cap rate = $1,250,000
$100,000 income ÷ 6% cap rate = $1,666,666
Net Operating Income ÷ Value = Rate
$100,000 income ÷ $1,111,111 = .09% rate
$100,000 income ÷ $1,250,000 = .08% rate
$100,000 income ÷ $1,666,666 = .06% rate
Value x Rate = Net Operating Income
$1,111,111 value x .09% rate = $100,000 income
$1,250,000 value x .08% rate = $100,000 income
$1,666,666 value x .06% rate = $100,000 income
- Note the relationship between the rate and the value. As the rate goes down, the value increases. If you’re a seller; you want to sell for a 5% CAP rate, if you’re a buyer; you want to buy for a 10% CAP rate..
- Net operating income (NOI) is a calculation used to analyze real estate investments that generate income.
- NOI equals all revenue (apartment rents and coin-op laundry) from the property minus all reasonably necessary operating expenses (utilities, maintenance fees, management fees, liability insurance and taxes).
- Note that mortgage principal and interest are not considered operating expenses; they are debt service, and they get subtracted from NOI to determine Net Cash Flow.
Gross Rent Multiplier or GRM
GRM represents the number of months’ rent it would take to pay for the house if the buyer pays cash up front…the lower the GRM, the better. This is an oversimplification, of course, but GRM can help a buyer to determine which house might make sense to purchase, or what the target price would be for a potential purchase.
- A key element in the GRM calculation is the estimate of monthly rent income.
- It is important to use actual RENTED unit data, not current list prices.
- Once you calculate GRM for your 4-6 comparable properties, the average GRM is used to estimate a price or value for the multifamily house or mixed-use property.
- A good real estate agent is a valuable asset to buyers in helping you navigate this process.
*Note that GRM does not reflect any operating expense, property taxes, or management costs; to include those elements in your analysis, calculate a Capitalization Rate (CAP rate), which is an expression of Return on Investment (ROI) for rental properties.