# Net Operating Income & Gross Rent Multiplier: Definition & Calculation

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

Net operating income and gross rent multiplier calculations can help a real estate investor quickly evaluate prospective purchases and measure performance. We will also look at some of the other formulas investors use for their investment analysis.

## Performance Measures

Craig is a buyer of rental real estate properties. His investment analysis methods include looking at performance measures, such as net operating income and the gross rent multiplier. Other performance measures include the cash flow, rate of return, capitalization rate, cash-on-cash return, and total investment return. These measures can evaluate a property before Craig purchases it and evaluate ongoing performance after the purchase. Let's explore the definitions and see how Craig uses these formulas.

## Net Operating Income & Formula

Net operating income is the total income a property generates minus necessary expenses. Income comes from rents and other sources, like a parking fees and vending machines. Necessary expenses include items like insurance, property tax, utilities, and repairs. They do not include the interest and principal payments made on a mortgage. Depreciation and capital expenses, such as a roof replacement instead of a repair, are also not subtracted in this formula.

NOI = (Total income) - (Operating Expenses)

## Gross Rent Multiplier Formula

Craig likes to use the gross rent mutiplier to see if he is paying too much for a property. The formula takes the purchase price and divides it by the monthly rent of the home. If the property costs \$100,000 and brings in \$1000 a month, the GRM is 100. If another property that also generates \$1,000 costs \$120,000, the GRM is 120. A lower GRM means less money is tied up in the house and is an indicator that the house will be more profitable than a higher GRM property.

GRM = Purchase Price / Monthly Rent

## Other Performance Measures

Here are some additional performance measures an investor can use to evaluate a property.

### Cash Flow

A cash flow statement identifies the cash income and expenses of a real estate investment. The point of the cash flow statement is to provide an at-a-glance view of how money comes into the business and goes back out. It is the sum of three parts:

• Operations - best described as regular daily expenses; tracks income received along with the common expenses of property management, the mortgage, taxes, supplies, repairs, etc.
• Investing - track cash spent on longer term investment considerations, such as improvements to a property like new windows or updated appliances
• Financing - covers business financing items, such as issuing stock in the company that owns the home

### Rate of Return

So what does Craig's investment really make? Investors want to know what to expect from their investment. Rate of return is typically expressed on an annual basis and makes a convenient measure to compare to different investments, like stocks or bonds.

Rate of return = ((Investment Gain - Investment Cost) / Investment Cost) * 100

If Craig's property has rental income of \$15,000 a year and costs \$10,000 a year to own and maintain, the rate of return would be:

(\$15,000 - \$10,000) / (\$10,000)

(\$5,000 / \$10,000) = 0.5

As per usual, multiply by 100 to get a percentage.

0.5 * 100 = 50% rate of return

### Capitalization Rate

Capitalization rate , or cap rate, is another measure of real estate investment performance. The capitalization rate helps an investor determine the potential of any given investment. The cap rate changes based on fluctuations in many factors. The rate shifts as incomes, expenses, and the market value increase or decrease over time.

Capitalization rate = (Net Operating Income / Current Market Value) * 100

So if a property has an NOI of \$6,000 annually and the current market value is \$100,000, the cap rate is 6%. If the market value rises to \$120,000 but the NOI is the same, the rate becomes 5%. If the property values stays at \$100,000 but the NOI rises to \$8,000, the cap rate is now 8%. With these numbers in mind, it's possible to see how at a given income and value the returns of an investment have a maximum potential. The actual returns will be smaller because of inaccurate or unexpected expenses.

### Cash-on-Cash Return

The cash-on-cash return metric expresses the return on investment in relation to how much cash Craig has put into the deal. Because a property can be bought with financing, it is possible to realize profits from the entire value of the investment with only a small portion of that value put up as cash to buy the investment.

Cash-on-cash return = (Annual Cash Income / Total Cash Invested) * 100

Let's say Craig buys a property that costs \$100,000 after closing costs and puts down \$20,000. The property generates \$400 a month after paying the mortgage, insurance, taxes, management, and maintenance costs. Joe's cash-on-cash return looks like this:

(\$400*12) / \$20,000

(\$4,800) / \$20,000 = 0.24 = 24% cash-on-cash return

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