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:
|Less Mtg. Payment for the Year||-$7,876|
|Cash Flow after mtg. |
|Down Payment (Investment)||20%||$35,300|
|Return on Investment |
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.