As an investor, don’t let these two disconnects between you and your REALTOR® cause you to lose out on a good investment. One is a failure to communicate clearly, the other is inflexibility.
Common Ground--Getting to Net Income
Both of you are attempting to determine if a property is worth buying. As a first step in achieving that, both want to know how much money is left over after expenses. So both take the gross income the property generates and subtract the operating expenses to arrive at net income.
Is There a Failure to Communicate?
Now you both correctly use the net income to arrive at a fair value for the property. Yet here’s where the first apparent disconnect in communication can occur.
- The REALTOR® will tend to use a Cap Rate (Capitalization Rate), basically a percentage, applied to the net income to arrive at an estimate of value. The formula looks like this:
Value = Net Income divided by the Cap Rate.
Value = $13,600 ÷ 8.5% = $160,000.
Because many Buyers do not grasp the notion of a Cap Rate they might disregard this approach.
- Instead many buyers tend to use a multiplier (basically a price-to-earnings multiplier) to estimate value. The formula looks like this:
Value = Net Income times the Multiplier.
Value = $13,600 x 12 = $160,000.
So with one method you divide; with the other you multiply. Yet either way leads to the same or a similar end.
Turning a Cap Rate into a Multiplier and Vice Versa
Though the formulas seem to be at odds with each other, in reality one is simply the inverse of the other. In other words,
- To turn a Cap Rate in a Multiplier you simply divide the Cap Rate into 100.
For example: 100 ÷ 8.5% gives a multiplier of 12.
- Equally, to turn a Multiplier into a Cap Rate you simply divide the Multiplier into 100 as well:
For example: 100 ÷ 12 = gives a multiplier of 8.5%.
The Second Real Difficulty lies in determining what percentage or multiplier to use. At times a buyer will say they use a multiplier of 10 times net because they heard it from someone. Yet such a rigid approach can lead to missing out on a good investment. For example:
Let’s say the current market Cap Rate of 8% converts to a multiplier of 12.5. At a net income of $10,000 the value of a property is about $125,000. Insisting on a multiplier of 10 would underestimate the value to $100,000, effectively cheating oneself out of a good investment. Market conditions establish the multipliers to use.