Many investors have a favorite strategy for weeding through the numerous income properties on the market in their search of a solid investment. Some use the “price-per-door” as a benchmark. Others consider the “gross rent multiplier (GRM)”. Yet others are convinced that capitalization (cap) rates are the way to go.

Which evaluation tool is best?

Investors have asked me the above question numerous times. A more profound question would be, “Is there really a BEST way? Let alone a right or wrong way?” Let’s explore some of the common comparison strategies.

Price-per-square foot

This technique is extremely easy to apply. Simply take the building price and divide by the number of total square footage of improvements. Thus, a 12,000 square-foot property with a list price of \$1 million has a price-per-square foot of \$83.33/sq. ft. This can be a useful tool when comparing different properties in a demographic area. It is not, however, without its limitations. For example, this method does not take income or expenses into account. Evaluating a property exclusively with this method and you could find yourself money pit and you wouldn’t even know it.

Gross Rent Multiplier (GRM)

The gross rent multiplier is another simple comparison tool, one that is slightly more useful than the price-per-square foot method. To calculate the GRM of a property, simply divide its sale price by its gross rental income. For example, a property listed at \$2 million that brings in a gross rental income of \$200,000, then it would have a GRM of 10.

The property’s GRM is useless unless you have a good idea of typical GRMs of similar properties. Armed with this information, the GRM is a great way to filter obviously overpriced properties. Be careful, however, because the GRM method, like the price-per-square foot technique, fails to figure in expenses.

Price-per-door

This is a popular method. Simply divide the property’s list price by its number of dwelling units. While I look for low price-per-doors during my property search, I use caution because, like the price-per-square foot method, it fails to account for income or expenses. The following illustrates my point.

One Main Street
Price-per-door: \$90,000
Gross Potential Annual Income \$110,000

Five State Street
Price-per-door: \$140,000
Gross Potential Annual Income: \$210,000

While One Main Street has a much lower price-per-door than Five Main Street, it also generates \$100,000 in annual income.

Capitalization (cap) rate

This method is the most comprehensive method of them all. Take a property’s Net Operating Income and divide by its sales price to come up with its cap rate. Since the net operating income already accounts for expenses and income, it is undoubtedly the most complete evaluation method. Of course, without scouring the rent rolls and income statements, it is difficult to tell whether a listing’s numbers are accurate.

The best thing to do during your search is employ a variety of the above. Know that none in inclusive and always proceed with caution. There is no shortcut for due diligence. Until next time, happy investing!

Kyle is a real estate investor and a consultant for Epifany Properties, a company that offers the full gamut of services any Real Estate Investor would need to include investment analysis, buyer representation, portfolio management, property management, sales and syndication.

1. I’ve heard that cap rate is relatively useless for evaluating anything other than large commercial properties. Can you really use it effectively for 4 units and less?

2. I’m also interested in learning which if these techniques is best used for which property types?

• Positive cash flow for one investor (who doesn’t understand cash flow) is a huge loser for another. What do your clients typically consider to be positive cash-flow, Bob?

3. Cap rate is a great indication of a properties operations. Many investors look at cash on cash return, LTVs, etc. I believe you must take all of them into account and make sure you have multiple exit strategies so the result is a very solid low risk deal.
.-= Ryan Moeller´s last blog ..Cash Flow Duplex =-.

4. Dave: It depends. If there are sufficient comparable income properties in the immediate area, the cap rate method is still very useful as an evaluation tool.

Bob: Residential isn’t exactly my specialty; however, one should always consider cash flow. Investors can’t even obtain commercial loans unless they can sufficiently prove that it will cash flow. Thus, projected internal rates of return are a great way to find solid investment properties.

5. Mike Henderson on

Cap rate is used on 95% of all commercial and apartment deals that I see. I like cap rate the best.

For residential deals you can still figure out the cap rate. Cash flow works as well. I’m familar with the Mike Ohio/Bigger Pockets 50% rule.

The other thing that I really like as well for residential property is replacement cost in this market. The market is so upside down right now (not normal market conditions) this is another good benchmark. Get this from your insurance agent when you are getting the costs on your policy. You should be able to say you are looking at a 3/2/2 of x sq. ft. in a particular zip code. They should say it costs x to replace that structure. When you have a positive cash flow and the replacement cost is 50K above your costs buy buy buy!

Bottom line is do them all. I do if it’s my money.

The other methods cost per door, GRM etc. are the best way to eliminate properties when you get ready to purchase figure out the cap rate.