Negotiate on Investment Property: Negotiating the Price of Income Property
There are many different methods of determining the value of an investment property. These include capitalizing the income of the property or determining the return on the actual cash invested. However, the most commonly used “quick method” for real estate income property is the gross income multiplier.
For example, Sam owns a 23-unit apartment building. His total rental income is $20,000 a month, or $240,000 annually. What’s the value of Sam’s building?
Sam may tell you that the gross income multiplier for his area is 10. Therefore, his property is worth $2,400,000. How did he arrive at this figure? He simply multiplied the gross annual income by 10 ($240,000 X 10 = $2,400,000). That’s the value, according to Sam.
Beware—the multiplier does not take into account the cost of borrowing money. Depending on interest rates and the amount financed, you may or may not be able to afford an income property, regardless of what the multiplier says it’s worth.
When actually calculating the gross income multiplier, a percentage of the gross annual income is usually deducted for vacancies—sometimes 5 percent.
What should be apparent is that if the value of any property is going to be determined in large part by the multiplier, the question becomes, “How did Sam arrive at a figure of 10?” The amount of the gross annual multiplier, therefore, becomes a deal point, to be negotiated. (After all, it will help determine the price.) Knowledge, again, is king when negotiating.
If you know how the multiplier was determined, you are a long way ahead of the other party, who doesn’t. The multiplier is strictly a rule-of-thumb method, there is no set multiplier fixed in stone. It’s what anybody thinks it is. Having said that, let me further say that the idea of a multiplier is a bit more scientific than I’ve made out and, properly used, can be quite helpful.
The multiplier is found by once again looking at comparables. Take the most recent sales of half a dozen comparable income properties. Then divide the actual sales price by the gross annual income and you have a multiplier. Take the average of all six properties’ multipliers and you have a fairly accurate number that you can apply to your property.
If done as indicated above, the multiplier can be a very useful tool. In fact, I’ve found that it is extraordinarily accurate, as con firmed by other methods. Of course, negotiations revolve around how comparable the other properties are and what the current property’s true gross annual income is (not always as easy to deter mine as it seems it should be).
Many owners and buyers, unfortunately, don’t do a thorough job of researching comparables to come up with a true multiplier. Rather, they call up a few real estate agents and ask, “What’s the income multiplier in this area?” The agent, who may or may not know any thing about this, might say, “7,” or “17,” or whatever. Suddenly the number takes on mythic proportions and the buyer won’t pay more or the seller accept less. Don’t accept anyone else’s word for the multiplier until you see it documented with comparables.
Beware of “historic” multipliers. Sometimes an area will explode in value and multipliers will jump up. However, a year or so later, the explosion is over, and those multi pliers may settle back down. Expect that sellers may still refer to the old numbers. Be sure you see that, whatever multiplier you use, it’s current with the times.