And so we come full circle with the financial aspects of successful real estate investing. After the long and winding road, we have arrived at our destination. At least for me, I have to agree with the general drift of Cervantes in the classic Don Quixote, the road is better than the Inn. On the road to a destination is generally the best part, arriving (at least for me) has always had a certain melancholy feeling to it. Nonetheless we are here, so let's dive right in and look at some of the commonly used investment analysis tools.

Gross Rent Multipliers

GRM is not really a commonly used tool, but basically it is just what it sounds like. Take the gross rents for a property and multiply them by a number (the GRM) to arrive at value. so if a property produced 100,000 in Gross Rents per year and the investor wants a GRM of 11, this property is worth $1,100,000 (100,000 x 11) to her.

There are two kinds of GRM, Gross and Effective. Gross uses gross rents one would recieve if the building was 100% occupied all year. Effective is based upon Gross rents minus a vacancy factor, say 7% for example.

The benefit of GRM is its simplicity. The drawback is, well, its simplicity. Such a simple number does not account for differences in expenses, management, etc.

Capitalization Rate

The "Cap Rate" is probably the most widely used measure of investment value by investors. Again, I think it is because of its simplicity and really it is a similar concept to GRM but it is based on Net Operating Income (not including mortgage interest), so it is a little more useful. Being based upon net income it accounts for expenses.

Let's say a property produces net income of $56,000 per annum and that today's cap rate for this kind of property is 7.5%. The formula is a bit different, division instead of multiplication, 56,000/ 7.5% = $746,600.

As you can see, capitalization rate is also simple to use, but it is not easy. Cap rates vary widely depending upon type of property, location, vacancy rates, market conditions, etc.  As well cap rates are best used for properties with relatively consistent income from year to year. A cap rate is too simplistic a measure for properties with varying net incomes (or years with losses). Because most commercial real estate investments have varying income, cap rate is really not the best measure of a property's value. For this reason it is often misused, but many investors use it because it is simple and because, well, everybody else does it!

Cash On Cash

Cash on Cash is simply how much cash an investment produces in a year divided by how much cash the Investor invested. So if I bought a building for $1,000,000 but only put $300,000 cash in and financed the rest, and if the building produced a net income of $85,000, AND (almost done) if my annual debt service (mortgage payments) were $57,000 my cash flow is 85,000 - 57,000 = $28,000. So 28,000/300,000 = 9.3% cash on cash.

A lot of investors uses cash on cash because "Cash Is King". While this sounds impressive and certainly has a lot of wow factor, it is really a lot of sizzle without any steak. A real estate investment is a long-term investment, despite what the seminar you went to told you. Cash is certainly important, no doubt about it, but it is far from the entire picture. The big picture takes into account all monies put into an investment over its life span and all monies out - which brings us to Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

IRR is my favourite for three reasons. First, its complicated and makes me look smart when I use it (well sorta). Secondly, it takes everything into account including money invested during years of losses, opportunity cost, the cost of not buying the next best investment (Modified Internal Rate of Return or MIRR - the most accurate of the accurate). Thirdly, it accounts not just for what money one receives but when one recieves it and when one puts more money in.

Of course, the main drawback is its complexity. Directly related to the compliexity is the accuracy of the assumptions used. One must make various assumptions several years into the future including vacancy rates, interest rates, lease rates, etc., so its accuracy is dependent upon the accuracy of the assumptions. But a properly done IRR is invaluable for assessing a property's investment potential.

Net Present Value (NPV)

Ranking right up there with IRR is NPV. NPV is a simple concept but a complicated calculation. Simply put, one analyzes all the projected cash flows from an investment and measures them against their desired rate of return. If the Net Present Value (value in today's dollars) of the investment is positive then the investment is worth purchasing. If the NPV of all future cash flows is negative, the price is too high.

It is a little complicated but a well-done NPV is a very powerful tool for analzying potential investments.

And speaking of well done, I've got to run! I can hear the sizzle of my steaks on the barbeque and I do like the steak as much as the sizzle. Bye for now. Oh - and remember, the road is better than the Inn - enjoy your investing trips.