Michael's Commercial LLC

GRM vs. CAP Rate

by Michael Setunsky

Which method is more viable as a way to value a real estate investment, the Gross Rent Multiplier (GRM) or the Capitalization (CAP) Rate? Let's look at these two methods one at a time and then compare the two.

Gross Rent Multiplier

The GRM also called the Gross Income Multiplier is a very rough "Rule of Thumb" approach to valuing an investment. Webster's New Collegiate Dictionary defines a rule of thumb as a general principle regarded as roughly correct but not intended to be scientifically accurate. In other words the GRM is a ballpark estimation tool for assessing the market value of an income producing property.

Calculating the GRM:

Market Value / Annual Gross Income = GRM

Median GRM: 5.33

Calculating the estimated Market Value:

GRM x Annual Gross Income = Market Value

The CAP Rate or Capitalization Rate is the rate of return on an income producing property for the first year. Calculating the market value is more detailed using the CAP Rate.

Calculating the CAP Rate:

Net Operating Income (NOI) / Market Value = CAP Rate

Median CAP Rate: 7.50

Calculating the Market Value:

Assumptions: Vacancy Rate = 10% - Operating Expenses = 38.62%(1)

NOI / CAP Rate = Market Value

GRM vs. CAP Rate

There is more than a $200,000.00 difference between the market value using the GRM and the CAP Rate methods. Notice that GRM does not take into account the Vacancy Rate or the Operating Expenses. These two items can significantly change the market value, as demonstrated above.

In summary, the GRM may be useful for providing a rough estimate of value when initially comparing properties to determine if a more in depth analysis is required. Once you have narrowed down the potential properties, the CAP Rate method should be used for a more accurate analysis.

A final thought. No matter which method is used, the outcome is only as good as the information initially obtained. Strive for initially acquiring accurate and reliable property data prior to completing your analysis.

About the Author: Michael Setunsky is the Broker and owner of Michael's Commercial LLC serving the Northern Virginia commercial real estate market. His more than 23 years of experience as a commercial real estate and business broker has earned him the distinction for being one of the top commercial real estate producers in the Mid-Atlantic Region. He also serves on the Mid Atlantic Real Estate Marketing Association's (MAREMA) Board of Directors, and is a Commonwealth of Virginia licensed Instructor. He teaches Pre-licensing, Post Licensing Education, Broker's and Continuing Education courses. Visit his company web site at http://michaelscommercial.com/.

Do I Need a Business Valuation?

by Michael Setunsky

Do I need a valuation to sell or purchase a business opportunity? If you are selling a business, a valuation will give the Seller a very good idea as to what the value of the business may be on the open market. If you are purchasing a business, a valuation with give the Buyer an opinion as to where the Seller stands in a competitive market. Whether you are a Seller or a Buyer, a valuation will assist you in making an informed decision as to the basis for the sales price.

Let us first look at it from the prospective of the Seller. Obviously, the Seller wants to get every dollar from the sale of the business. However, if the sales price is too high, the Seller will price the business out of the market and limit the number of potentially well-qualified buyers. If the sales price is too low, the Seller will loose money on the transaction by giving away the business. How do we make this a Win-Win situation? One way is to value the business properly with up to date information and data.

Buyer's usually base their financial decisions on hard data that will produce a viable income stream with a positive cash flow. In other words, can the Buyer put money in their pocket after the expenses and debt service are paid? Additionally, buyers do not like to purchase potential. Unfortunately, potential does not pay today's bills and expenses. A properly priced business will provide the Buyer with a positive cash flow. If the sales price is too high, it will not offer the Buyer, the required income stream to operate the business successfully.

This statement is worth repeating: Buyer's usually base their financial decisions on hard data. This means, if a Seller cannot show a Buyer all the income on paper in the P&L (Profit and Loss) Statement and/or Tax Returns, the Buyer will likely walk away from the deal. Just like potential, a Seller cannot sell income not reported on the financial documents. Furthermore not reporting all earned income in against the law.

The following is a checklist of information required from the Seller to complete a proper business valuation. (Note: This is not an exhaustive list. Additional information may be required.):

1. Current Balance Sheet.
2. Profit and Loss Statements - Last three years (preferably five years) plus current year-to-date statement.
3. Federal Income Tax Returns - Last three years (preferably five years).
4. Current Lease and all related documentation.
5. Franchise Agreement, if applicable.
6. Documentation on any loans on the business.
7. Current list of Furniture, Fixtures and Equipment (FF&E) with Fair Market Value of each item.
8. List of current Inventory with date of purchase for each item.
9. List of Accounts Receivable (Aged).
10. Leasehold Improvements with In-Service dates.

As you can see, the Seller plays an important role in developing a proper valuation of the business. In the end, the valuation is only as good as the information provided by the Seller.

Now, let us look at it from the Buyer's prospective. A Buyer does not want to pay more for the business than it is worth and additionally, the Buyer wants to make sure they are getting what they are paying for in the price. The Buyer should have a valuation prepared to see if the asking price is viable as part of the Due Diligence process. The valuation will give the Buyer peace of mind or it can serve as the basis for negotiation, if the sales price is too high.

About the Author: Michael Setunsky is the Broker and owner of Michael's Commercial LLC serving the Northern Virginia commercial real estate market. His more than 23 years of experience as a commercial real estate and business broker has earned him the distinction for being one of the top commercial real estate producers in the Mid-Atlantic Region. He also serves on the Mid Atlantic Real Estate Marketing Association's (MAREMA) Board of Directors, and is a Commonwealth of Virginia licensed Instructor. He teaches Pre-licensing, Post Licensing Education, Broker's and Continuing Education courses. Visit his company web site at http://michaelscommercial.com/.

What is a CAP Rate?

by Michael Setunsky

The Wikipedia defines the Capitalization or CAP Rate in part as:

            A contraction of capitalization rate, the cap rate is the assumed rate of return on an investment in real estate. The cap rate is commonly used in the valuation of commercial and investment property because it directly links the value to the income produced by the property.

To determine the cap rate of a property, divide the net operating income by the sales price. From an income standpoint, the higher the cap rate, the better the deal.

Note that a higher cap rate results in a lower value. Thus, newer properties in upscale areas will tend to show lower cap rates than their less desirable counterparts.

Retrieved from "http://en.wikipedia.org/wiki/Cap_rate"

As an example for establishing a CAP Rate and ultimately determining the Sales Price for a property, let us use a 10 unit apartment building. The market rent for each unit is $1,500.00 per month for a total Gross Income of $180,000.00 per year. An estimated 1 unit is vacant at any given time. This gives us a Vacancy Rate of 10% (1 unit / 10 units = 0.1 or 10%). Before we can determine the CAP Rate, we have to resolve the Effective Gross Income (EGI). The EGI is derived by taking the Gross Income and subtracting the Vacancies and Collections. This gives us an EGI of $162,000.00 ($180,000.00 - $18,000.00).

Our next step is to calculate the Net Operating Income (NOI). The NOI is derived by subtracting the Operating Expenses from the EGI. The Operating Expenses consist of all the costs associated with the operation and maintenance of the apartment building (e.g., taxes, insurance, utilities, payroll, administration, property management fees and reserves for replacement). Operating Expenses do not include mortgage payments, capital expenditures and depreciation. The EGI is $162,000.00 and our Operating Expenses are $42,000.00. The NOI is derived by subtracting the Operating Expenses from the EGI. This gives us an NOI of $120,000.00 ($162,000.00 - $42,000.00).

The CAP Rate is determined by the commercial real estate market for the specific type of property and geographic area. The CAP Rate is specifically derived by looking at other apartment buildings in the local area that have recently sold. By using the formula CAP Rate = NOI / Sales Price for three to five comparable apartment buildings in close proximity, we can determine the CAP Rate for apartment buildings in the local area.

                                                 NOI                      Sales Price                       CAP Rate

     1.      Comparable #1   $105,000.00              $1,400,000.00                       7.5%

     2.      Comparable #2   $112,500.00              $1,500,000.00                       7.5%

     3.      Comparable #3   $131,250.00              $1,750,000.00                       7.5%

Looking at all three CAP Rates, we can choose a rate of 7.5% to use in our analysis. Based on our NOI of $120,000.00 and a CAP Rate of 7.5%, the Sales Price for our apartment building is $1,600,000.00 (NOI / CAP Rate = Sales Price).

Here is a summary of the math formulas:

     •     Gross Income - Vacancies and Collections = Effective Gross Income (EGI)

     •     Effective Gross Income (EGI) - Operating Expenses = Net Operating Income (NOI)

     •     Net Operating Income (NOI) / CAP Rate = Sales Price

Of course, if you know the Sales Price and the CAP Rate you can find the NOI:

     •     Sales Price x CAP Rate = Net Operating Income (NOI) or

If you know the NOI and Sales Price, you can acquire the CAP Rate:

     •     NOI / Sales Price = CAP Rate

The most difficult part of this whole process is developing the CAP Rate. If you do your homework and find the appropriate comparables, you should have no problem with the CAP Rate.

Note: The analysis here is only for demonstrating the Capitalization process and formulating a Sales Price on a property for marketing purposes. The intent here is not to circumvent consulting with an Appraiser and obtaining an appropriate appraisal on the property.

About the Author: Michael Setunsky is the Broker and owner of Michael's Commercial LLC serving the Northern Virginia commercial real estate market. His more than 23 years of experience as a commercial real estate and business broker has earned him the distinction for being one of the top commercial real estate producers in the Mid-Atlantic Region. He also serves on the Mid Atlantic Real Estate Marketing Association's (MAREMA) Board of Directors, and is a Commonwealth of Virginia licensed Instructor. He teaches Pre-licensing, Post Licensing Education, Broker's and Continuing Education courses. Visit his company web site at http://michaelscommercial.com/.