Price to rent ratio, versus cap rates

Price to Rent Ratio versus Cap Rates

You may have heard me mention that 51% of all investors are new to real estate investing. Well I am currently working with one of these new investors and they have the best questions. I just love when new investors ask questions that show they are doing their proper diligence on the investment property.

Before the recession most people were banking on appreciation and just interested in the structure diligence of the property. The best property in the best condition has no merit to a purposeful investor if the property does not make financial sense. So the question that was asked is one I have seen before so I wanted to share it with all of you.

The questions

What is more important the rent to price ratio or the cap rate?

Before we get into my response as to which is best let’s look at a few of the evaluations used and how and where to best use them. We will use the example of $100,000 property and a $1000 rent for each example so you can easily see the different comparison methods.

·         Price to rent ratio: Also known as a GRM (Gross rent multiplier) as the term suggest this method looks at the price of the property  in correlation to the annual rent. The simple formula: purchase price divided by Annual rents. So a $100,000 property which rents for $1,000 per month (12 months x $1,000 is $12,000 annual rent). $100,000 / $12,000 = 8.33. So when you are just beginning your diligence on a property and find the price and rent you can quickly assess the Price to rent ratio. As you evaluate a number of properties you can quickly assess which property surfaces to the top as the better investment. These better looking investments will warrant your time to do some deeper diligence.

·         The 1% rule: Does the property meet the 1% rule? This is a simple quick look at a properties financials to see what merit it may have to you as an investor. The 1% rule suggests a property should rent for 1% of the purchase price. So a $100,000 property should rent for $1000 per month. $100,000 / $1000 = 1%. As you can see this is similar to the price to rent ratios but looking at it in its simplest form. This is a very quick snapshot to assess a property for possible merits. Just drop 2 zeros from the price to establish where rents should be and then verify if indeed you can rent for this price. It does not get any easier than that. Again when comparing this to other investment properties you can easily see which property may have the best merit?  Note: as markets tighten it gets harder and harder to find properties that match the 1% rule. So when you do you will want to evaluate the property itself for deferred maintenance to insure sustainability of the positive cash flow.

·         The Cap Rate: an abbreviation for Capitalization rate is the ratio of net operating income (NOI) to the property value. To establish a cap rate you want to know a little more detail. You want to know not just the gross rent but also all the monthly expenses, these monthly expenses get subtracted from the gross rent to give you the NET annual rents. The Formula to establish cap rate is net operating income divided by purchase price. So using the same numbers from above we want to add one additional step. This step is subtracting expenses from the gross rents above to determine Net income. Let’s assume expenses are $100 per month or $1200 per year. So we take the $12,000 gross rent subtract the $1200 expenses to get $10,800  NOI ($12,000-$1200=$10800) now we can calculate our cap rate NOI/Price ($10,800/ $100,000 = 10.8%) the higher the cap rate the better the investment

So let me ask you this question, Which is the best formula to determine the best investment property? You can see the price to income ratio and the 1% rule are quick analysis with limited information to quickly determine which properties appear on the surface to be a better return on investment.

The cap rate however requires you to do deeper diligence and identify what the actual expense are. This formula uses net numbers and this will always give you a better overall picture.

Lets break it down

As an example: a rent of $1,000 per month on a $100,000 purchase suggests you have a 1% rent to purchase ratio. However what if you have identified 3 different properties that rent for $1,000 per month each priced at $100,000 and each making the 1% ratio but each property has different expenses that you the property owner has to pay for.

·         What if one property may have you paying the water bill

·         What if one property have you paying water and Electric bill

·         What if one property does not have you as landlord paying any utilities.

In this case they all still make the 1% rule but as you determine what expenses you as a landlord have you can more precisely see Which would be the better investment?

So the 1% rule while a good quick analysis still warrants deeper scrutiny.

Subsequently the price to rent ratio will also be subject to these variances.

The cap rate will always tell you the clearer picture:

As the formula is NET operating income (not including any debt service) divided by price. so in the example above the net operating income will be different for all 3 of these properties and the only analysis that identifies this is the cap rate reflect as it requires NET numbers. Because the owner pays different expenses for each of these 3 examples the net operating income is different for each property and therefore the cap rates for each property will be different and provide the truest picture.

The price to rent ratio is great for a quick analyses to see if you want to take the time to dig deeper and learn what the cap- rate is but the cap rate is going to give you a truer picture.

Think of it this way. The more work you have to do to find a number the better info you will uncover, hence the term Due diligence.


Bonus: Final note

Another great tool the Cap rate provides is to give you a true picture of return on investment regardless of how you pay for it. Notice we exclude debt service (mortgage payments) when we arrive at net income. Whether you finance 80 % 70%, 50%, or even pay cash outright for the investment the cap rate will remain constant which is why debt service never gets included as expense in a Cap rate calculations.