When buying and selling their property, many people have difficulty determining an appropriate value. Too many factors influence the market value. These include the location, the substance, the size of the property, the land, rental income, operating costs and many other points.
However, there is a rough calculation used by many brokers and real estate investors: the broker formula. This determines the purchase price and—in the case of rental properties—is more closely related to the expected gross return. If you are actively looking around the real estate market or want to sell your apartment or house, you should know these terms and their meaning: broker formula, multiplier and factor.
The Broker Formula Explained
Brokers in particular like to use a formula named after them to determine the approximate market value of a property. This is a simplified form of the income approach, a calculation for determining the value of real estate.
When you hear this term, you should be able to classify the result of this calculation. The broker formula is:
Net rental income ÷ capitalization rate = property value
This equation is based on assumptions or actual figures. Net rental income is the property income remaining after deducting operating costs. Operating costs are allocated to the tenants. Consequently, this is the net cold rent. For owner-occupied homes, a customary local comparative rent must be applied.
The capitalization rate is the base interest rate adjusted for the property risk. As a rule, the current real estate loan interest rate should be used and modified here. The value is somewhat higher when the risk is taken into account—depending on the condition and special features of the property. For typical residential properties, the common assumption is 4% to 6%, or slightly lower with good interest-rate conditions.
What You Should Consider When Using the Broker Formula
The result of the formula is intended to reflect the approximate market value of the property. However, several special factors must be taken into account:
- Actual rental income may be higher or lower than the customary local rent.
- Unusual repair costs can affect rental income. Net rental income does not always have to correspond to annual income.
- For A rough calculation uses an expected capitalization rate. This is based on assumptions and empirical values. However, it does not always correctly cover all risks associated with the property, such as a backlog of modernization.
- Even small changes to the variables can have a significant impact on the final result.
- The following applies to brokers and prospective buyers: They do not always have all the required actual data and must work with estimates.
Broker Formula: Calculation Example
The approximate market value of a property could be determined as follows: An average apartment building with three apartments generates annual rent of 23,400 euros. The capitalization rate is assumed to be 3.9% due to a low interest rate on loans and low risk. This results in the following calculation:
23,400 euros ÷ 3.9% = 23,400 euros ÷ 0.039 = 600,000 euros
The approximate market value is therefore 600,000 euros. Even with a monthly rent that is just 100 euros higher, the increase in value is over 30,000 euros. Conversely, with a capitalization rate that is 0.6 percentage points higher, the value decreases by approximately 53,000 euros. You should therefore determine the individual variables in the calculation very thoroughly. Deviations or incorrect assumptions can be fatal.
Derivatives of the Broker Formula: Determining the Factor and Multiplier
An even simpler method can be derived from the broker formula, which is particularly interesting for rental properties. If you divide the specified sale price of a property by the net rental income, you obtain the so-called factor or multiplier. For the example above, this would look as follows:
600,000 euros ÷ 23,400 euros = 25.64
The result of this formula is a period in years. This period shows you how long it would take to recoup your investment costs for a rental property and start making profits. If you were to purchase this example property, you would therefore have to wait 25.64 years for the purchase price to pay off.
Warning: This calculation does not take into account additional purchase costs such as brokerage fees and notary fees! You should include these costs in an individual assessment. Rent changes, tax depreciation and future changes in value are likewise not included in the calculation.
In practice, it is usually the other way around: Brokers and sellers state a factor such as 17, 20 or for25 or 26, respectively, in the example above. This factor is the multiplier of the rental income, from which the purchase price is calculated by multiplication. The multiplier is generally based on regional comparative and empirical values.
Both the factor or multiplier and the broker’s formula are commonly used on the real estate market as parameters for a simplified valuation. Important: The location, building fabric, state of modernization, land and many other details are not covered at all or only inadequately.
Good to know: The gross yield is derived from the factor and multiplier
With this insight, you as a prospective buyer (and seller) can calculate very well. If you have a mathematical inclination, the key point will already be apparent: Both calculations are directly related, even beyond the property value.
The result in number of years from the second calculation is the mathematical reciprocal of the capitalization rate from the broker’s formula. 1/25.64 is 0.039, or 3.9 percent. With a factor of 25, it would be 4%; with a factor of 20, it would be 5%; and with a factor of 17, it would be around 5.8%.
The interaction between the broker’s formula and the factor therefore conceals another important figure for the buyer: the gross yield. The capitalization rate corresponds to the expected gross yield. This is important for assessing the purchase price. Although the calculation includes a capitalization rate through the risk assessment, this is not identical to the percentage financing costs for the property loan. Rather, as described, it includes a risk premium for the location, condition of the property, etc.
You should compare both values before making a purchase. Compare your percentage financing costs from interest and repayment with the calculated gross yield or the capitalization rate from the broker’s formula. This should be lower than your personal percentage financing costs. If your personal rate offered by the bank is above the capitalization rate, you will pay more month after month than you receive in rent. If, on the other hand, it is lower, you will generate a surplus that you can use for maintenance measures, special repayments, as a reserve or at your own discretion.
Specifically, this means for the example mentioned above: You should only buy this property if itsare below the assumed capitalization rate of 3.9%, including repayments for the property loan. The lower the rate, the higher your net return.
Important: This return comparison applies particularly to rented properties. As a buyer, you should never have to pay extra for ongoing costs. However, if you want to occupy the house or apartment yourself, this calculation only applies to a limited extent. The comparison nevertheless gives you a good indication of whether the purchase price is too high or attractive.
Broker formula provides only an approximate value
The factor or multiplier, as well as the capitalization rate in the broker formula, are only approximate indicators. Nevertheless, good brokers and experts with excellent knowledge of the local market can come very close to the actual value of a property with their calculations. Local comparative values and empirical values, among other things, are what make broker formulas and multiplier calculations attractive.
A more precise price calculation is based on a comprehensive valuation procedure, a so-called valuation report. This takes significantly more factors into account. On the open real estate market, such valuation reports are particularly common in auctions. When selling through a broker or in direct private sales, however, the purchase price is predominantly determined using the broker formula or factor calculation.
To assess prices better, consider how the variables interact. The rule is: The higher the risk (= capitalization rate) and the worse the location, the lower the factor and purchase price should be. The lower the risk and the better the location, the higher the factor and thus the purchase price will be. Pay attention to local comparative values for similar properties. Also bear in mind that these are only approximate guidelines that disregard many details. If you do not trust the results of the broker formula, commission a precise valuation report. This provides somewhat more security, but is subject to a fee.