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IF YOU'VE EVER DABBLED with income-producing real estate, you’ve probably heard some jargon and buzz words like yield rates, cap rates and gross rent multipliers. What do these mean and how do people come up with these numbers?
These are rates and ratios which can be useful in evaluating income property. But, like all statistics, they can be confusing and misleading if based on faulty information or used in the wrong way.
Stock market investors use similar indicators, such as the price-to-earnings or P/E ratio. Analysts can determine if a particular stock is over-valued or under-valued based on their knowledge of standard and historic P/E ratios. However, some companies use creative accounting methods to report their earnings, making the P/E ratio less meaningful. Savvy stock market investors know they need to consider a variety of things, such as growth potential and risk and the time value of money. Real estate investing is no different.
Yield Rates
A yield rate is the rate of return on capital. There are all kinds of yield rates, but the one most of us know best is the interest rate. Interest rates, like all yield rates, are usually expressed as a compound annual percentage rate. Mortgage interest is usually compounded monthly, while the interest on a standard savings account may be compounded daily.
Other types of yield rates are the discount rate, the internal rate of return (IRR), the overall yield rate and the equity yield rate. In fact, there are dozens of yield rates used in analyzing commercial real estate. But they all express the same thing – some rate of return on money.
The Gross Rent Multiplier
The gross rent multiplier (GRM) can be useful in estimating value because it requires only the most basic knowledge about a sale – the sale price and the annual income. The GRM is a ratio rather than a yield rate, and is simply the sale price divided by the potential gross income (PGI). Technically speaking, PGI is the anticipated next year’s rent. However, in most cases the current or asking rent can be used.
The standard rule of thumb for gross rent multipliers is somewhere around 10. This means that the market value of an income-producing property should be roughly 10 times its gross annual income. Lower GRMs are found where buyers pay lower prices and/or expect higher rents. Higher GRMs are found where buyers pay higher prices and/or accept lower rents because they expect property values to rise.
On the Mendocino Coast, for example, GRMs tend to be below 10 in Fort Bragg (a regular working class town) and above 10 in the village of Mendocino (a tourist-oriented town with historic buildings and design control).
Gross rent multipliers can also be based on effective gross income (EGI), which is PGI minus vacancy and collection losses. However, it’s often difficult to find this kind of detailed information about real estate sales. It’s important that the GRM be based on consistent information for each property. You can’t mix potential and effective income and come up with a reliable multiplier.
Recent sales of similar income properties should produce similar gross rent multipliers. If the GRMs are not similar, the data may be faulty or the properties may not be truly comparable. They could be located in different neighborhoods or they could be different in age, quality, condition and functional utility.
Some types of properties, such as vacation rentals and single family dwellings, produce income but don’t generate reliable GRMs. That’s because their rental income is secondary to their use as private residences. Also, these types of properties often have excess land, or more land than is needed to support the income-producing use. Mixed-use properties, such as homes with rental units, usually don’t produce reliable gross rent multipliers either.
Rent Surveys
The most reliable way to estimate income is to determine market rent, which is the most probable rent the property would bring based on an analysis of comparable rental space. This involves conducting a rent survey. Ideally, current rental and vacancy information should be available from the local Chamber of Commerce or Board of Realtors. However, in small towns and rural areas it usually isn’t.
A rent survey is a time-consuming process which involves interviewing landlords and tenants and measuring rentable square footage. Rents, vacancy rates and square footage are constantly changing, so rent surveys have to be constantly updated.
The Cap Rate
The overall income capitalization rate, or cap rate, is another useful ratio for estimating real estate value. The term cap rate is misleading, because it implies that this is some kind of yield rate, like a mortgage interest rate. The cap rate is just a plain old ratio like a gross rent multiplier, but is derived from more precise information. The cap rate is the net operating income (NOI) divided by the sale price.
Capitalization is a fancy word for the process of converting future benefits to a present value. The main benefits from income property are rent and the future sale of the real estate (called the reversion). These require time, management and some element of risk to obtain.
Cap rates can be developed by analyzing the income and sale prices of comparable properties. Cap rates are generally more precise than gross rent multipliers because they are derived from net rather than gross income. Cap rates are more sensitive to such things as vacancy rates and operating expenses. Because older buildings tend to have higher operating expenses, cap rents also reflect the age, quality and condition of the improvements.
The main problem with using cap rates is the difficulty in collecting consistent detailed real estate information. Different owners report expenses in different ways. For example, an owner who also manages the property may not include management fees as an operating expense. Also, many owners don’t include reserves for replacement as a standard expense item.
Putting together accurate income and expense records is a lot of work. Some buyers and sellers consider this information to be confidential. However, because it requires some effort to assemble, this information it is often incomplete, inaccurate and not fully disclosed as part of the sales transaction.
But sooner or later lenders and informed buyers are going to ask about cap rates. Being able to provide an accurate cap rate could make the difference between getting or not getting a loan, or making or losing an important real estate deal. Therefore, it’s important to extract this information whenever possible.
The standard rule of thumb for cap rates is something less than .10 (10 percent). Higher cap rates are found where buyers pay less and/or expect more rent. Lower cap rates are found where buyers pay more and/or accept less rent because they expect the value to increase during the holding period.
Some companies publish standard cap rates for various types of properties in different parts of the country. However, the best information is always derived from the local real estate market.
The Relationship Between Yield Rates and Cap Rates
Yield rates and cap rates are related, even though they are two different things. A yield rate is a rate of return on capital, like an interest rate. A cap rate is just a ratio (income divided by sale price). When a buyer expects income and property values to remain unchanged during the holding period (the time the buyer expects to own the property), the cap rate is equal to the yield rate. This is called capitalization in perpetuity.
When a buyer expects income and/or property values to rise, the cap rate is lower than the yield rate. In other words, the buyer will pay more for the property because they anticipate increased future income.
Discounted Cash Flow Analysis
There is another more sophisticated way to analyze income property which has become more common with the widespread use of computerized spreadsheets. This is called discounted cash flow analysis, or DCF. The process is also called yield capitalization. It’s complicated because it projects income and expenses for a number of years, ending with the sale of the property.
DCF can be useful for analyzing large, complex properties with multiple income streams. By plugging in different numbers, investors can test their assumptions and decide whether or not to buy the property and how much to pay.
DCF spreadsheets are also used to analyze land subdivision and development projects. Although these spreadsheets are impressive, the results can be speculative and misleading. Discounted cash flow analysis may be more useful as an analytical tool than as a way to estimate value.
Discounted cash flow analysis is different than direct capitalization – a simple process which projects only one year of stabilized income and expenses. For the vast majority of income properties, direct capitalization simulates the process used by buyers and sellers to arrive at a sale price.
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Chet Boddy, Real Estate Appraisal, Sales and Consulting
43300 LR Airport Road, #59, Little River, CA 95456
707-937-4011, office
707-937-4818, fax
chet@chetboddy.com
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Copyright © 2002 Chet Boddy, All Rights Reserved
Chet Boddy is a Certified General Real Estate Appraiser, Realtor“ and real estate consultant who has lived on the Mendocino Coast since 1976. Look for this and other real estate columns on Chet’s web site at www.chetboddy.com
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