Perhaps you have decided that now is the time to invest in real estate, or maybe you own a piece of income property and would like to know how much an investor would value the parcel at; this article is here to help. In this article I will explore the two most basic and commonly used income property valuation methods, first, the gross rent multiplier (GRM),  and secondly, capitalization rates (cap rates).

When looking at investment property, the most important piece of advice I can give you is to remain objective! It does not matter how “cute” the property is, or if you would live in it personally. Look at the income and expenses; if they make sense and the property is in good repair then the property makes sense; keep the emotion out of the equation, your not living there.

The first and quickest way to start valuing property is the GRM. GRM is a very simple calculation that can be done in a few minutes and will give you an indication on a property’s warrantability as an investment. To calculate the GRM, you simply take price (or market value) and divide it by the annual gross income. For example, if a property is on the market for $1,000,000 and the annual gross rent is $100,000 then the GRM is 10. To effectively use GRM as a tool for evaluation in a specific market, an investor should gather a list of recently sold properties and calculate an average GRM for that area. Once you have the area average, you can use it to find fair market value of properties on and off market based on annual gross rents. For example, if the area average GRM is 8 and you are presented with a property with an annual gross rent of $60,000 then you can easily calculate the market value by multiplying $60,000 x 8 and get the value of $480,000.

Please keep in mind that GRM does not account for differences in the actual condition of the building, so a property that has had major renovations or upgrades should sell at a higher GRM then one in need of some work. Additionally, GRM varies greatly by neighborhood, so you need to get an average for each area you intend to analyze and invest in – real estate is local, even in investment property. Lastly, as a rule of thumb, the more established and desirable an area is, the higher the GRM will be and there is typically an inverse relationship between GRM and risk.

GRM=PRICE/AGI or PRICE=AGI*GRM

A quick example using 72 Calumet Street in Mission Hill, an investment property recently listed for sale.

GRM=$1,099,000/$105,600=10.4

Once you have identified a list of properties you are interested in via the GRM, the next, and more detailed analysis is to calculate the capitalization rate (or commonly referred to as the cap rate, or simply cap). A cap rate gives you the percentage return earned on your investment, if you paid for a building in full, and also represents a mechanism by which to derive (market) value for a property. Obviously, most of you will be using some type of debt service to finance your purchase, but everyone’s debt terms are different so cap rates are used to normalize the analysis. Cap rates have a lot of similar characteristics to GRM, but unlike the GRM, account for the actual expenses associated with a property. A word of caution on expenses; keep in mind when looking at public listings there is often incomplete information on expenses, and what information there is needs to be scrutinized. You should familiarize yourself with common expenses such as water, sewer, insurance, management, and taxes so that when you are looking at quoted expenses you can plug in the most realistic numbers possible. Some of these numbers are set in stone such as taxes, however some vary greatly based on your style of ownership. Moral of the story is you need to familiarize yourself with the costs associated with your style.

Now that you have done some research on expenses, you are ready to start calculating cap rates; which is actually just as simple as calculating the GRM. The first step is to get the annual gross income for a property. The annual gross income (AGI) is simply the sum of monthly rent times 12. The next step is to calculate the annual operating expenses (AOE). The typical annual operation expenses include the sum of property taxes, insurance, management, water, sewer, and maintenance and repair. Once you have AGI and AOE you can calculate your annual net income (ANI). This is done by simply subtracting AOE from AGI. Now that you have your ANI, you simply divide this by the asking price, multiply by 100 and you get your cap rate.
A quick example using 72 Calumet Street in Mission Hill:

AGI=$105,600
AOE=$22,239
ANI=AGI-AOE=$105,600-$22,239=$83,361
Cap rate= (ANI/asking price)*100= ($83,361/$1,099,000)*100=7.6

This means that if you bought this particular building, at full asking, with no debt service, you would earn 7.6% on your money.

Typically, investors buy properties with a vision for improvement. Because of this, they will often calculate two cap rates, the current cap and an expected future cap based on some planned improvement after purchase. This gives them a metric to base the cost benefit of the planned improvement.

Now that you have the basic tools to start looking at investment property, get out there, start number crunching and learn about your markets! Don’t have time? Feel free to contact me for some assistance on finding the right investment property for you or additional information on how to make these calculations.

On October 14th, 2009, The Boston Landlord and Investor Group, a 2,000+ member strong organization, will hold their annual conference with the theme Investing in Real Estate: How to Proposer in the New Economy.

The free conference aims to provide an informative overview of Boston’s current real estate market, and will assemble four Boston real estate experts that will speak about the local real estate investment market, future real estate trends, and opportunities to invest in Boston.

Guest speakers for the event include:

• Jeanine Hall, VP of Lending at Citibank
• Simon Butler, Executive Director at Cushman & Wakefield (Sold in excess of 25,000 apartment rental units valued at more than $3.2 billion)
• Debi Benoit, Vice President at Coldwell Banker (Sold more than $725 million in real estate and Wellesley’s #1 broker from 2006 through 2008)
• Terry Hillery, President of Hillery Holding Company (Privately held real estate company with an established track record of successful Boston developments)

The conference will provide an opportunity to learn what local real estate experts are doing, what they think you can do in order to profit in the new real estate economy, and what their predictions are for the future.

When: Wednesday, October 14, 2009 at 6:30 PM
Where: Citibank (1st floor) 491 Boylston St. Boston, MA 02116 (between Clarendon St. and Berkeley St. in Back Bay)

To register for this free event, please RSVP to Matt Martinez at: info [at] landlordandinvestor [dot] com. For more information, please call (617) 448-5550.

While the Boston real estate market has remained relatively resilient in the face of the US housing slump, there is a niche within the residential real estate market that most oftentimes flies completely under the radar of downward trends.  Parking spaces.  These small deeded pieces of land represent a viable option for investors who seek investment vehicles for available cash.

The acquisition of parking spaces in downtown Boston represents a risk-mitigated means by which to enter the real estate investment arena, and has the capability of producing a steady return on investment above and beyond what is available via common investment vehicles that are leveraged for both short and long term semi-liquid investments, such as certificates of deposit or money market accounts, which at present, are returning 2% per year at most.

Simply put, the supply of parking spaces in downtown Boston has not increased quickly enough to satisfy demand (see Snowed In? Garage Parking Spot Investment Looks Clear).  The simple concept of supply and demand is tried and true.  The investment numbers tell a positive story as well.  Take a $50,000 parking space in the South End of Boston purchased with cash, assume monthly rental income of $225, a vacancy rate of 5%, and after accounting for HOA expenses, you have approximately a 5% pretax return on your equity investment.

Despite the downtown Boston residential market maintaining strength, there has been a host of both rumors and news stories about market activity, such as auctions, that inevitably create uncertainty and ambiguity in the market as it relates to value.  In the face of that situation, deeded parking spaces, which are purchased in a very similar manner as to any other piece of real property, present the real estate investor a viable means by which to invest into the downtown Boston market, while at the same time not subjecting themselves to the same types of risks inherent with housing investments (see current list of Boston parking spaces for sale).

Savvy real estate investors know that the 1031 Exchange is an important tool that, when utilized properly, allows the investor to defer capital gains tax on property that is sold at a gain. So what is a 1031 Exchange? A 1031 Exchange is an exchange of one property (referred to as the “relinquished property”) for another like kind property (referred to as the “replacement property”) under the rules of Internal Revenue Code §1031. In a 1031 Exchange, the investor places the proceeds of a property sale in escrow with a “qualified intermediary.” These funds are then used to purchase the replacement property, and the investor does not pay tax on income gained from the sale of the relinquished property.

The requirements of a 1031 Exchange include: (i) the transaction must be an exchange through a qualified intermediary as opposed to a sale and purchase; (ii) the replacement property must be like kind to that of the relinquished property; (iii) the same taxpayer must dispose of the relinquished property and acquire the replacement property; (iv) both properties (i.e. the relinquished property and the replacement property) must be held for investment purposes or for use in the investor’s business; (v) to defer all tax the replacement property must be greater in value, equity, and debt than the replacement property; and (vi) replacement property must be properly identified pursuant to IRS §1031 within 45 days of the closing of the relinquished property.

While it has been established that a personal residence is not eligible for a 1031 Exchange as it would violate the requirement that the property be held for investment purposes, IRS Revenue Procedure No. 2008-16 has created a safe harbor for property held for productive use in a trade or business or for investment under Section 1031 even though the taxpayer occasionally uses the property for personal purposes. However, the property must meet certain qualifying use standards, which include, for both relinquished and replacement property, minimum requirements for length of ownership and days rented, as well as maximum requirements for days used for personal use. The other key aspect of the qualifying use standards is that the relinquished and replacement properties must be rented at fair market value.

Through proper planning and analysis, real estate investors can leverage the 1031 Exchange to their advantage. However, that analysis and the rules governing it can be quite complex. Therefore, please consult with your legal and tax advisors as you contemplate your next 1031 Exchange.

If you are a real estate investor, or perhaps a vacation home owner, today’s Wall Street Journal article covering changes in tax law for second homes will be of interest to you. A recent bill passed through Congress that will change slightly how tax breaks are calculated on a second home.

Some Republicans complained that the move would hurt the second-home market. Rep. Kevin Brady (R., Texas) said the change would punish those who had saved to purchase a second home. Rep. Sam Johnson (R., Texas) called it a “luxury tax on retirement homes.”

Under current law, a person can exclude from taxes up to $250,000 in capital gains on the sale of a principal residence. Up to $500,000 of gains can be excluded for married couples. A second home can become a principal residence as long as the taxpayer has lived there for two of the previous five years.The bill approved yesterday would change those rules. Under it, the size of the tax break for a second home would be tied to the portion of time, out of all the years a house is owned, that it serves as a principal residence. Living in a property longer would result in a larger tax break on any gains when it is sold.

These changes can, in part, be credited to the government’s attempt to provide tax relief to homeowners facing foreclosure. Not entirely fair you say, perhaps true.