If you are a real estate professional then you know about the gross income multiplier, GIM or the formula that determines the value of rental real estate. It has been used for decades.

There are many schools of thought on how to determine the value of rental property but I always use my readings as a rule of thumb.  Any real estate textbook will tell you not to invest in a property with a GIM of more than 8.  The formula is simple enough: divide the price by the gross annual rents to get the GIM.

With this definition in mind it seems that particular author wants me to never pay more than 8 times the annual rent for a rental property.  This helps the buyer open their eyes to mow much of a rental property they can afford to buy.  It makes plenty of sense really.  Seems that if a property was selling for 6 times the rental income, then that was a really good deal.  I mean anything higher than 8 times the rental income and that becomes a dangerous proposition.  This simple method makes it easy for the average Joe to know what they are getting into. 

Still it is a crude method of figuring out the true value of the investment property.  It is almost too simple in that it doesn't take into account other extraneous expenses like taxes and up keep.  For instance, what if the property already includes utilities to its tenants as part of the rent?  That changes the equation, doesn't it?  You could subtract the annual expense of the utilities to get a more accurate value but there are other considerations to think about as well.

The GIM will constantly be in flux due to market changes and in other words, you must also consider interest rates and how that will influence the value. Also, every property is different and has different needs to be a viable rental.  This means just plain different expenses for different properties, whether higher maintenance costs, insurance premiums, or whatever. The gross rent doesn't say much about the factor that really makes a rental property valuable: the net income.  Many investors if not careful might find themselves with a cash cow.

The key is accurate valuation of the investment property.  You want the property to work for you and instead of against your better judgment right?  This is what the valuation should be based upon, not other factors. This is one reason why a capitalization rate, or "cap rate" to determine value should be used. Simply explained the cap rate is the rate of return expected, or the rate of return on a property at a given price.

For instance, let's begin with the gross income of a property and subtract all expenses, but not loan payments. For this property, let's say the gross income is $80,000 per year, and the expenses are $34,000, you have net income before debt-service of $46,000. It will be important to apply the capitalization rate to this figure because the debt to income ratio will impede upon the value.

Let's say that for your area of the country, the normal capitalization rate is .10 or a 10% return on the value of the investment.  It may be possible that the rate is higher making it more difficult for you to buy anything but let's see.  Now divide the net income of $46,000 by .10, and you get $460,000 - the estimated value of the building. With a cap rate of .08, meaning an 8% return, the value would be $575,000.

You could also consider that the cap rate is supported by the fair market asking price of the property based on comparables of the area.  For this, just divide the net income by the asking price. For example, if a seller wants $675,000 for a property, and the net income is $55,000 you would divide 55,000 by 675,000. This gives you a cap rate of .81. 

 Value equals net income before debt-service divided by cap rate. Sounds like a simple equation but does it relate value accurately?  When buying an investment property, it is important to get an accurate depiction of the true expenses per year and not an overestimated jumped income.  I mean this could be a blessing or a disaster if the seller has with held information and let's say the property need more work than found upon inspection.  Also let's say the seller only shares with you projected rents and then you come to find people are not really paying on time or tenants move out after the sale.  Where does that leave you? All of these hypotheticals could leave you upside down.

I mean much of the actual income will be determined by the rate of interest at which you are borrowing because you may have a higher rate than another investor.  Something as simple as a down payment may throw off your formula.  The cap is a good thing to use but it only demonstrated numbers.  You also have to include the more human factors when purchasing also.  Still the cap at least gives you a more realistic vision of what to expect.