Investors are crowding into the buyer’s market today and they all want to know the same thing: “Is this property going to pay off?”
Any agent can answer this question with two simple formulas:
- the capitalization rate (cap rate); and
- the net income multiplier (NIM).
The cap rate is pure profit — the amount of money remaining after all of the owner’s property expenses are deducted from the gross income produced by the property — expressed as a rate, or percentage. Most real estate investors will have a specific cap rate in mind when shopping for income-producing property. This rate may be realistic or not, depending on the current market.
To find a property’s cap rate, a buyer’s agent must first have the following data:
- gross operating income (GOI) from the property (the rent amounts paid by the building’s current tenants and the scheduled rent amounts for vacant units);
- property operating expenses (taxes, maintenance and repairs cost, etc.); and
- the purchase price for the property.
Having obtained the above information, the agent must calculate the net operating income (NOI) of the property by subtracting all property expenses from the GOI:
GOI – operating expenses = NOI
Next, the agent can find the cap rate by dividing the NOI by the purchase price:
NOI ÷ purchase price = cap rate
Once the agent has found the cap rate, the buyer can decide if this cap rate is high enough and whether the cost of purchasing the property will pay off in the end. If the cap rate from the listing price seems too low, the buyer’s agent can use the inverse of the cap rate formula to find a purchase price more in keeping with his buyer’s desired cap rate.
First, find the NIM; this is the reciprocal of the cap rate. Since a cap rate is expressed as a percentage, or fraction of 100, this can be done by dividing 1 by the cap rate:
1 ÷ cap rate = NIM
Next, find the buyer’s desired purchase price by multiplying the NOI by the NIM:
NOI × NIM = purchase price
What the buyer wishes to profit from the property and what he can realistically expect to profit may be two different things. However, an agent who knows how to find a property’s cap rate and NIM can cut through a jungle of expenses and variables to show his buyer an investment property’s bottom line in minutes.
Remember: knowledge is the key to success in today’s real estate market!