Becoming a Landlord
Investing in Los Angeles Real Estate can be a profitable venture. One of the keys to becoming a successful real estate investor is knowing your numbers. Math makes up an important part of buying and selling Multifamily Real Estate. Understanding this math, along with other factors, is essential to getting started on the right foot. Below are some of the fundamental concepts and terms defined.
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GRM- The Gross Rent Multiplier is a ratio of the of a buildings purchase price to its gross annual rents. For example, a building with a purchase price of $1 million generating $80,000 in gross annual rents has a GRM of 12.5 ($1,000,000/$80,000). The GRM can be viewed as a demand indicator for a neighborhood or property. Apartment buildings in beach communities can sell for 15-30 x’s gross rents, while buildings in Hollywood, where there is more supply and less demand relative to an LA Beach Community, may only command 12-18 x’s gross.
The GRM is easy to calculate and is very straightforward, but does not take into account expenses or the operating income. The GRM is an easy way to sort through several multifamily options quickly, but further analysis is required to make the ultimate decision.
Cap Rate: The Cap Rate is the ratio between Net Operating Income (NOI) to the price of the asset, or simply put NOI/Price. A building generating $80,000 in gross annual income will have vacancies and
expenses of approximately 40% of its gross rents, so for our example, our sample building will have a CAP Rate of 4.8% ($48,000/$1,000,000). This metric should also be compared to other like properties that have sold and are listed in the same area.
Cap rate is short for Capitalization Rate. It is the return expected assuming an all cash purchase. Mortgage costs are not taken into account in a cap rate calculation.
Use the Cap Rate like you would the GRM (for comparison to like properties in the same neighborhoods). If the prevailing Cap Rate for similar properties to our sample is 4%, then our sample property is a good value (yielding slightly better at 4.8%). We can calculate the value of our sample building by solving for “Price,” since we know the market Cap Rate and the NOI. In this example, our building, which is listed for $1 million is worth $1,200,000 (Value=$48,000/4.0%=$1,200,000).
The Cap Rate is used as an industry standard for multi-family valuation.
Cash on Cash Return: This is simply Cash Flow/Invested Capital. With most investors having debt obligations, the Invested Capital is the down payment.
Return: This metric is similar to Cash on Cash Return. (Cash Flow + Principal Reduction)/Capital Invested. Although the principal reduction advantages are only realized after a sale, the equity build is undeniable.
Why Real Estate Investing
Leverage– Leverage is the use of the banks money to increase profit, but the use of it can also be risky and dangerous. Someone purchases a home for $100,000, pays full cash, and the property value appreciates $10,000 in one year. This deal yields a 10% return. The same person purchases 10 homes for $100,000 each with a 10,000 down payment per home. They spend the same $100,000, except the 10% appreciation ($10,000 per home) yields a $100,000 profit or 100% return. This is leverage.
Cash Flow: When you buy a home or rent, money comes out of your pocket. When you buy a cash producing asset, money flows into your pocket.
Principal Reduction– On top of Cash Flow, tenants will reduce the principal owed on your asset every month and amortization is friendly to time.
Appreciation: Over the long run, real estate investments appreciate as rents rise, and several factors can accelerate or slow this process. Appreciation in real estate serves as a great hedge against inflation.