Which is more important: rent to price ratio or the cap rate?
There are a few questions in particular that just tickle me as when they pop up I know I am talking to a serious investor. When that investor is also someone who I met when they just started as a beginner it’s even more exciting. One of those questions was asked recently by a client of mine. She wanted to know what method of evaluating a property is more effective, a property that has a great cap rate, or; a property that shows a higher rent to price ratio.
Well, hold my coffee and let’s discuss:
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 are we looking for properties that have a GRM to be higher or lower?
Let’s look deeper. Let’s assume this monthly rent was increased to $1200 instead of $1000 per month. At $1200 rents x 12 month the annual rent would be ($1200 x12 =$14,400 annual rent. so now we calculate GRM $100,000 / $14,400 = 6.9. so you can see the Lower the GRM # is the better the deal. This is an important distinction as looking at Cap rates we are looking for properties which have a lower GRM number to be the better deal.
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 (GRM). 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%). So for cap rate do we want a higher number or a lower number such as within the GRM equation.
Let’s also raise the rent of this property to $1200 as we did above. At $1200 rent we learned we have gross income of $14,400, less the $1200 expense gives us net income of $13,200 ($14,400 less $1200 = $13,200 ) now to calculate the NOI we take net operating income / Price. so $13,200 /$100,000 = 13.2% Cap Rate. so walla we just learn that unlike the GRM where we want a lower number to show us the better deals, with Cap rates the higher the cap rate # the better the investment.
Now, let’s visit the 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. When you narrow down the best properties you can then dig deeper, which is preciously what the cap rate analysis does for you.
The cap rate indeed requires you to do deeper diligence and identify what the actual expenses are. This formula uses net numbers and this will always give you a better overall picture. When driving around looking at properties, perhaps following up on lead from advertisements etc. you often do not know all the details. You usually know the price and you may know the rents. Which you can use GRM or the 1# rule as a quick assessment of which property surfaces to the top.
Breaking 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 have to pay for.
· What if one property may have you paying the water bill
· What if one property has 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 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.
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.
The author’s opinion cannot be construed as tax or legal advice, and may not represent the views of HTBUSA or its stakeholders. HTBUSA is not a legal service or professional tax service. As with any investment, there is an inherent risk in investing in real estate.