Last week we looked at capitalization rates (cap rates) and cash-on-cash returns as measurements of investment value. Today we will highlight a few other ways you might see investments evaluated.
Similar to cap rates and cash-on-cash returns, the following are formulaic ways to determine an investment’s value by comparing different investment variables. The results can be easily compared with other investment opportunities to determine which investment is more valuable to the investor.
In this second part, we will look at gross rent multiplier and return on investment.
Gross Rent Multiplier (GRM):
GRM evaluates the value of an investment property based on the price of the property and the gross scheduled annual income, or the total potential income a property could generate if it was fully occupied for the entire year. The resulting GRM would tell you how many years it would take to earn back the amount invested in the purchase of the property. GRM is a very simple and quick calculator that can offer you a comparable potential value of an investment.
Gross Rent Multiplier = Price/Gross Scheduled Annual Income
Negatives to GRM: No investment only factors in the initial investment amount and a fully achieving income rate. The GRM does not factor in an investment property’s expenses, additional investment contributions that may be necessary, or vacancies. The GRM is very limited and will not provide an accurate view of the investment as a whole.
A property purchased for $500,000 with a gross scheduled annual income of $40,000 would have a GRM of 12.5.
Return on Investment (ROI):
ROI uses the net income of an investment during a certain period of time compared to the investment cost to determine a percentage value of the investment. The net income is determined by subtracting all expenses and costs from the gross income. Cost of the investment could simply include the original investment price, but could also include any additional contributions made during the course of the investment period. It is also important to know the period of time for which the income, expenses, and investment costs are calculated; ROI could be calculated as a first-year return, or a total return at the termination of the investment.
Return on Investment = Net Income/Cost of the Investment
Negatives to ROI: ROI can be ambiguous if you do not have a clear understanding of all of the factors in the equation. At its best, ROI is used to evaluate investments where there are few transactions such as the purchase of stock that is then sold before any reinvestments are made or any dividends paid. A stock investment of $100,000 that is later sold for $250,000 has an ROI of 250%. The only problem here is that this does not take ‘time of the investment’ into consideration.
A 250% ROI calculated over a 7-year investment would not be as valuable as a 250% ROI calculated over a 3-year investment. With a real estate investment where additional contributions are added over time for maintenance or upgrades, late contributions will have as much effect on the ROI as early contributions. In reality, an investment with a 250% ROI earned off of a $50,000 original investment and a later contribution of $50,000 is more valuable than an investment with a 250% ROI earned in the same amount of time from a $100,000 original investment. Furthermore, financing will affect the actual profitability of an investment but will not factor into an ROI equation.
These valuation tools are useful because of their simplicity, but they have their limitations. In the final part of this series, we will look at Internal Rate of Return, which provides a solution for many of the shortcomings of the tools we’ve discussed so far.