One of the most common sayings among real estate investors is that you "make your money on the front side." That means the most crucial step throughout the entire process is finding a property that meets the investor's criteria. This can also be the most difficult step in the process. Because of the seemingly endless potential opportunities, a sorting mechanism must be used to quickly and effectively remove the static and highlight the true deals.

If the investment strategy is to cash-flow a property, then there are two rudimentary formulas that can help a deal-hunter sort through the options. The formulas are **Direct Capitalization Rate **and **Gross Rent Multiplier **(Cap Rate and GRM for short). Each of these formulas has 3 similar moving parts; simply, they are a price for the property, an estimate of its earning potential, and a measure of return. Though the formulas are very similar, they are used for different purposes.

First, **Direct Capitalization Rate **is more often used to determine at what rate a property will return the investment principal. The formula is:

**CAP RATE = OPERATING INCOME / PURCHASE PRICE**

**CAP RATE** is the measure of return and is expressed as a percentage

**OPERATING INCOME** is the cash inflow less the cost of maintaining the property (does not include debt service or tax implications)

**PURCHASE PRICE** is the principal to be invested (may also include improvement costs)

More often than not, this formula will be used to estimate the CAP RATE, rather than the other two components. So then. the question is, what is an acceptable CAP RATE? For residential rental property, anything above 12% is a healthy gain (compare this to other investment returns). However, an important assumption in this equation is that OPERATING INCOME does not take into consideration debt service. Therefore, this formula is best used for evaluating cash purchases, not financed purchases. Another implicit assumption is the time frame - it is usually an annualized figure. So, CAP RATE can also be thought of as the annual return of principal - if your CAP RATE is 10%, then 10% of the initial investment will be returned each year. An alternative way to use this formula would be determining at what price a specific property meets the CAP RATE criteria (i.e. what price to buy at).

The second formula, **Gross Rent Multiplier** is mostly used to estimate the market value of an income-producing property. The formula is:

**Gross Rent Multiplier = Market Value / Gross Scheduled Income**

**GRM **is the investment criteria and is expressed as a whole number.

**Market Value** is the estimate of the property's current market value (note in this formula, large number is on top)

**GSI **is the expected (annualized) income. **It does not take into account operating costs or debt service**

Since we're using this formula to quickly sort through various opportunities, the inputs will normally be market value and gross scheduled income - pieces of information that can be estimated from public data sources. The result of the GRM formula is a a whole number, which by definition, is a multiple of one year's **Gross Scheduled Income**. The GRM can be thought of as the number of years it will take for a property to equate to it's present market value (i.e. pay for itself).To put it another way, a GRM of 1 is where a property pays for itself in a single year, anything lower than that and it's a 100+% return on investment. So, *the lower the multiple the better the investment, and the higher the income the lower the multiple. *So a decent GRM is usually below 8, but can be much lower if you get in at the right price. In order to sort through the investment opportunities, it is good to set a stiff GRM criteria and stick to it.

Even though this formula is called **Gross Rent Multiplier**, it is commonly used to estimate a property's market value. However, this is market value from an investor's perspective (money driven) not an end user's perspective (utility driven).

These two formulas can be used off the cuff on just about any situation to get a ball park idea of whether or not a property is a good investment. Though, this screening process is only the first step in investment evaluation. Another common saying among investors is that only about 1 in 10 of the properties that seem like GREAT deals actually are.