Investors should know how to determine what to pay for an investment property. Of course the decision is subjective and depends on an individual’s tolerance for risk.
The most important number for an investor to find is the Net Operating Income of an investment property. In a nutshell Net Operating Income is what an investor is buying and what the lender is willing to finance.
An investment’s value can be estimated based on the projected rental income over a specific period of time. Investors and lenders both need to know that an investment property can pay the annual debt service and leave enough before tax cash flow to provide a cushion.
These specific calculations of value will help the investor to evaluate the economic soundness of the potential investment purchase.
I prefer using the capitalization approach when determining the estimated value of an investment property. First, you need to calculate the effective gross income, which is simply maximum yearly income from rents (100% occupancy) minus estimated vacancy and collection losses.
Once you know your effective gross income, you can find the net operating income which is the effective gross income minus annual operating expenses.
Operating expenses include taxes, insurance, utilities, management fees, maintenance and repairs. After you have determined the net operating income, you can find your value of the property by taking the NOI divided by the cap rate. Cap rate is an acceptable rate of return on an investment.
Acceptable cap rates vary based on the investor. Some investors are looking for a cap rate of 10 or more, while others are quite satisfied with a much lower cap rate. Riskier investments usually come along with a higher cap rate, the lower the price of the property the higher the cap rate. In a nutshell a 10% cap rate means the investor will recoup his investment in a 10 year time period. Another good way to determine one’s rate of return is through the gross rent multiplier which is the sales price divided by rental income. A gross rent multiplier of 120 means that an investor will recoup his investment in 10 years or over 120 months. After a bit of practice this will become second nature to you and you will easily be able to determine what to pay for an investment property.