If you’re considering buying an investment duplex in Minneapolis or anyplace else, which is the best measure to determine whether or not it cash flows? The cap rate? The gross rent multiplier? Or the one percent rule?
Remember, these measures are nothing more than first glance ways of turning apples and oranges into bananas and comparing the ripeness of each.
Never purchase a property without first doing a complete income property analysis, using actual rental income and expenses.
So which is the best quick measure?
The cap rate is simply the rate of return a property would produce if it were entirely paid for. It’s calculated by dividing the purchase price by the net operating income (NOI). Of course, NOI is determined by taking your total income for the year, less vacancy and expenses.
The gross rent multiplier (GRM) is arrived at by dividing the purchase price or present value by the total revenue the duplex could generate every year.
But what’s the one percent rule? It’s just another quick measure of an investment property’s performance. The theory goes that a property should be able to generate one percent of its purchase price every month in order to cash flow.
So, if a Minneapolis duplex is listed at $150,000, it should generate $1500 a month in income.
The trouble is, like the gross rent multiplier, it doesn’t factor in expenses. And expenses can turn investment properties with amazing GRMs or ratios of rent to purchase price into bad investmentments in a hurry.
Let’s say, for example, a duplex is listed for $100,000, meaning that the total monthly rent for the two units should be $1000 or more. Theoretically, it should cash flow, right?
But what if the property taxes are $5000 a year? Then will it cash flow?
Is the GRM a better measure? This fictitious duplex would give you gross annual rent of $12,000, leaving you with a gross rent multiplier of 8.33.
In most markets, this would be a cause for celebration. Unless, of course, the property taxes were, again, $5000, and the owner was responsible for an annual heating bill of $3500.
So is the cap rate the best tool?
In commercial property. Not so much in smaller multi-family units.
Why is that?
Because until the last two years, they generally hovered around a 2 cap. Maybe a 4.
The rule of thumb here is the higher the cap rate, the better the cash flow. (Of course, very high cap rates also tend to involve a greater amount of risk, but that’s a topic for another day.)
Duplexes, triplexes and four unit properties simply don’t generate as much cash as their large apartment complex cousins. They simply don’t have the number of units to do that.
However, they also tend to have more potential buyers, which makes them worth more in relation to their revenue.
So, if none of them is a perfect way to quickly determine whether or not a property is worth taking a closer look at, what is?
The answer is simply pick one of the afore-mentioned formulas that makes sense to you.
I use the gross rent multiplier. And I can’t tell you what a “good one” is. I’ve literally done thousands of spreadsheets to arrive at general ideas of what GRMs work in this market and don’t.
But I never call one of my investors about a prospective property without doing a complete analysis first.
A qualifying GRM is simply reason to stop and do the rest of the math.