Deal-Check Your Return on Income Property

In a previous article on income property, we touched on the cap rate (a %), and the multiplier (a #), the inverse of a cap rate. Both are used to arrive at an estimated value of a property with two or more rental units.

Each can be applied to the net income after expenses.

  • The cap rate is divided into the net:
    $13,600 ÷ 8.5% = a $160,000 value.
  • The multiplier is multiplied by the net:
    $13,600 x 12 = a $160,000 value.

Dividing 100 by 8.5 gives the multiplier of 12.

We also mentioned that some buyers use a multiplier of 10 time’s net income to decide on a purchase price. When such a rigid, one-size-fits-all approach does not reflect market conditions and therefore value, the buyer can miss out on a good investment.

Let’s say that in looking at a number of income property sales, they indicate an average market cap rate of 7.7%. This represents a multiplier of (100 ÷ 7.7) 12.99 times net income.
Let’s look at the difference in multipliers:

  • The net income of $13,600 x 10 (used by some investors) equals a value of $136,000.
  • The net income of $13,600 x 12.99 equals a value of $176,500 rounded to the nearest $500.

The value disparity of $40,500 is big to say the least and this can lead to failed negotiations.

What if the buyer is really saying he wants minimum 10% return on his investment to justify the purchase? That’s very different. As an Example: What then is the buyer’s return on investment on a purchase of $176,500?

The lender will mortgage 80% of the value with a minimum down payment of 20%. Amortized over 25 years with a 5-year fixed rate of 2.90%, the mortgage payment is $656.32 per month; this works out to $7,887 per year.

Let’s Use this Simple Deal Check to Gage Return:

Price 100% $176,500
Mortgage Amount 80% $141,200
Less Mtg. Payment for the Year -$7,876
Cash Flow after mtg.
& expenses
Down Payment (Investment) 20% $35,300
Return on Investment
(Down payment)

The Return on Investment is just over 16%

Yet the multiplier was 12.99 times net income to arrive at the price and not 10 times. The investment places above the buyer’s required return, making it a good buy.

Cap rates and multipliers vary depending on factors like market conditions, the mortgage market and rates, property location and property condition. Yet a simple deal check can help determine whether to buy or walk away.

Eugene Pilato

Eugene Pilato

Broker of Record
CENTURY 21 Today Realty Ltd., Brokerage*
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