The document discusses two methods for evaluating real estate investments: the cap rate and gross rental multiplier (GRM). The cap rate represents return as a percentage calculated from net operating income and purchase price, but can be misleading if income is exaggerated. The GRM is calculated from purchase price and rental income, with a lower GRM being better. It recommends ignoring cap rate and determining income using comparables or tax filings, then multiplying income by 7 to determine maximum purchase price.

1. How to Evaluate a
Real Estate
Investment

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2 Ways to Evaluate Your
Real Estate Investment
1. Cap Rate
2. Gross Rental Multiplier

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The cap rate represents the %
return you would get on a real
estate investment if you were to
pay all cash (fully capitalized).

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For example, if you were to buy
a $300,000 property for cash
and it paid you $30,000 a year
net operating income (NOI) then
your cap rate is 10%
($30,000/$300,000).

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Net Operating Income
(NOI) is your rental
income minus the
operating expenses of
the property.

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The problem with cap rate is
that it is based on numbers that
tend to be exaggerated. Either
income is projected to be too
high or expenses are projected
to be too low.

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If a property is $40,000 income
and has annual expenses of
$10,000 then the NOI is
$30,000. If the property is
selling for $300,000, then the
cap rate is 10 percent.

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What happens if the seller is
exaggerating the income and it's really
only $35,000 and the expenses are
really $15,000? Now the NOI is only
$20,000 ($35,000-$15,000) and the
cap rate is really only 6.67 percent.

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The higher the cap rate, the
better.
A recommended
minimum cap rate is 10%

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The GRM is a number based on
the sale price divided by the
actual annual rents. If the rents
are $40,000 and the purchase
price is $300,000, the GRM is
7.5 ($300,000/$40,000).

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The lower the GRM the
better.

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A good rule of thumb
is that the
maximum GRM should be 7

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If rents are $40,000, the
maximum purchase price
should be
$280,000 (7 x $40,000).

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To validate rental income look
at comparable rents for similar
properties in that area and then
apply a 5 percent vacancy rate.

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Another way to validate rental
income is to ask the owner for
their income tax filing for the
property for the previous year
and see how much rental
income they declared.

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3 Steps to Evaluate Rental Investments
1. Ignore cap rate.
2. Determine income by using comparison
method and owner’s tax filing.
3. Multiply rental income by 7 to determine
maximum purchase price.

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Check out my
book for a Step by
Step approach on
how you can get
started in Real
Estate Investing.
Real Estate Investing: The 7 Step Solution to Making Millions in Real Estate

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Jim Pellerin has been investing in real
estate for over 25 years. He is the
author of
Real Estate Investing: The 7 Step Solution to Making
Millions in Real Estate
Check out his blog at
jimpellerin.com