For most investors, finding real estate deals isn’t the hard part. The hard part is finding the high-yielding real estate deals, and learning how to evaluate them on the fly while your competitors are circling.
Digging into educational resources and using discount brokers will get you up to speed and cut your costs, but you’ll need to master metrics, such as gross rent multiplier, cap rate, and others, to truly crack the code of successful real estate investing.
The good news is that some of these figures, once you get comfortable with them, can be calculated on the back of a napkin. And if you just hate math, we’ll even explain a way you can invest in top-quality real estate — without having to evaluate any deals yourself.
Gross rent multiplier, or GRM, is a quick, easy little metric that you can calculate in your head. It’s not a comprehensive quality rating, but it can give you a general idea of how good a potential investment might be.
To calculate gross rent multiplier, you simply divide the investment’s purchase price by the total gross annual income.
So let’s say you’re looking at a commercial investment property that’s priced at $500,000, and could potentially bring in $100,000 in rent in a year. Dividing $500,000 by $100,000 gets you a gross rent multiplier (GRM) of 5. This means you’ll make back the purchase price in five years.
On the other hand, let’s say you’re looking at a similarly priced investment property of $500,000, except that this one will only bring in $80,000 a year in gross rent. This gets you a GRM of 6.25 — or about 20% worse than the previous property.
The lower the GRM, the higher quality the property. Although this metric has some obvious shortcomings — it doesn’t account for things like operating expenses or other loan amortization, and assumes a fixed rent in a market that may be quite fluid — it can be useful as a shorthand tool.
Net operating income, or NOI, is another barebones metric that can be useful when evaluating a real estate deal.
To calculate NOI, simply subtract your operating expenses and expected vacancy from the investment property’s gross income. What’s left is your NOI. It’s a basic snapshot of how much money a property is going to put in your pocket after you take care of your expenses. And isn’t that the main reason we invest in real estate?
So let’s say you found an intriguing property that could reasonably generate $4,000 in rent a month — $48,000 a year — and you’re assuming operating expenses (like insurance, property management, maintenance, expected vacancy, legal and accounting services, etc.) of $800 a month. This leaves you a monthly NOI of $3,200, and an annual NOI of $38,400, out of which you’ll have to take care of mortgage payments and property taxes — expenses that vary quite a bit between investors.
NOI isn’t quite the same thing as cash flow, though they sound similar. Cash flow takes expenses like property taxes and mortgage payments into account, which aren’t necessarily known quantities when you’re in the early stages of evaluating a property. NOI simply tells you how much cash you can expect to have on hand to take care of your financial obligations — whatever those end up being.
Cap rate, as it’s known to most investors, is one of the most popular methods of projecting an investment’s potential return.
To calculate cap rate, you’ll first need to calculate the investment’s NOI. Then you divide that NOI by the investment’s purchase price. That percentage is the annual rate of return, or cap rate.
If we use the example in the previous section, let’s say you’re looking at a potential investment with an annual NOI of $38,400. If the purchase price is $400,000, that gets you a cap rate of 9.6% — a very respectable annual return. On the other hand, if the investment is priced at $750,000, that would leave you with a much lower cap rate of 5.1%. Remember, the higher the cap rate, the better the investment is.
What we can’t tell you is what the threshold of a “good” cap rate is. That will depend on your investment goals, your appetite for risk, and factors like the type of investment property, and the current interest rates. But like the other metrics on this list, it’s useful for comparing different investments.
We should also note that the cap rate assumes you’re purchasing the investment in cash. If you’re going the more common route of taking out a mortgage on the property, you may want to check out cash on cash return.
If you’re borrowing money to buy your investment, the profit calculation is a lot different.
To figure out your cash on cash return, start by taking your NOI, and subtract your annual mortgage payment. This gives you your annual pre-tax cash flow.
You’ll then want to divide that by your total cash investment. Your total cash investment includes all the money you put into the investment upfront, including items like down payments and closing costs.
Let’s return to our example of a property that costs $400,000, and has an annual NOI of $38,400. If you took out a 15-year mortgage at 6%, and put 20% down ($80,000), that gets you a mortgage payment of around $2,700 a month, or $32,400 a year.
This gets you an annual pre-tax cash flow of $6,000. Your total cash investment is your down payment of $80,000, plus closing costs that we’ll estimate are 6% of the loan amount, which equals $19,200 in closing costs — for a total of $99,200.
To get your cash on cash return, you divide your annual pre-tax cash flow ($6,000) by the total cash investment ($99,200), which gets you a 6% cash on cash return.
If this type of investment sounds intimidating, it’s important to note that there are other ways of investing in real estate — without actually buying property.
REIT is an acronym for “real estate investment trust,” which is a company that owns investment properties like malls, hotels, warehouses, or apartment complexes. These companies pay a dividend to investors that’s based on the revenue they collect from the properties in their portfolio. For you, the investor, it’s a way to invest in a diverse array of investment properties, without taking on too much risk or overhead.
There are many different types of REITs. Some are publicly-traded, so you can buy in just as you’d buy a stock, while others are private. Some REITs actually own the properties in their portfolio, while others own debt securities backed by the properties. The right REIT for you is going to depend on a number of factors, including how much you want to invest (many private REITs have steep minimums), and your appetite for risk.
What’s clear, though, is that elite REITs can be very profitable. As of April 2023, the top-performing REITs have annual returns as high as 20%. While investing in a REIT may not be as viscerally satisfying as getting the keys to a piece of property, it can be just as profitable, if not more so!
