Diving into the world of real estate investments can be incredibly daunting for a first-time investor, even for those who have experience in other realms, like equities. However, by equipping yourself with the right tools and taking a measured strategy towards both your investment search and eventual purchase of an investment property, you can avoid many of the most common mistakes that befall new investors.
One of the ways you can save time while searching for properties and identify potentially profitable properties for your portfolio is by finding the Gross Rent Multiplier of individual properties, and, as an aggregated number, across neighborhoods, cities, or even entire states. In the following guide, we will take a solid look at what the Gross Rent Multiplier is, how to use it, and other critical concepts relating to GRM.
What is a Gross Rent Multiplier?
The term Gross Rent Multiplier refers to a property valuation method used by investors to vet, value, and compare investment properties and across property portfolios.
The difference between the Gross Rent Multiplier and other methods is the fact that it solely uses the gross income of a property relative to the price/value of a building to screen the property/portfolio. As such the metric is something of a blunt instrument in real estate analytics and is used primarily as an indicative screening tool rather than as a definitive indicator of value.
Simply put- the Gross Rent Multiplier is the ratio of the subject property’s price to its gross rental income. Many real estate analysts erroneously state that by using top-line revenue, the Gross Rent Multiplier can help an investor determine how long it will take for an investment property to be paid off using only the gross rent as an input.
GRM = Price/Gross Annual Rent
But of course it cannot be used to predict the amount of time it will take to pay off a property because other factors drive that period of time, not least of which is the burden of paying expenses that reduces available cash to amortize the cost of purchasing a building. As you can see from the formula above, the Gross Rent Multiplier is calculated by dividing the fair market value of a property or the property’s asking price if on the market for sale, by the estimated annual gross rental income.
For example, if an investor plans to purchase a rental property for $5 million with a monthly gross rental income of $46,000 we need to multiply $46,000 by 12, which comes out to $552,000 in rent annually.
Gross Rent Multiplier = Property Price/ Gross Annual Rent = $5 million/$552,000 = 9.06
So, we have found that the Gross Rent Multiplier for this property is 9.06.
As the GRM uses the gross rents as the denominator in the equation, it cannot be used to calculate any kind of payoff period for the property; only the net operating income (NOI) can do that. The NOI is the profit from operating a property that can be used to distribute to investors in the form of dividends or to pay off any loans made to purchase the property.
The GRM is used only as a benchmark for comparing one property against another. Professional developers typically look at so many properties that they need to employ quick screening tools to determine which are worthy of further investigation. The GRM falls into this bucket as do other ‘blunt’ tools like price per square foot, price per unit, rent per square foot and the like.
What is a Good Gross Multiplier?
We came up with a GRM of 9.06 years in our example. This number varies depending on a number of factors. The most important to be aware of is that it will gradually decrease as the market cycle lengthens and property prices increase. Early on in the real estate cycle, as the market emerges from a recession, the GRM will typically be relatively low as investors return to purchasing properties as liquidity begins to slowly come back into circulation. High single digit GRMs may be the norm in such circumstances.
As the cycle extends and cash for investment becomes more readily available, both from lenders and from equity investors, prices increase faster than rents and the GRM goes up – perhaps into the teens.
Remember, when you work to calculate the Gross Rent Multiplier, it is imperative to remember to consider all operating costs before pulling the trigger on a property. Just because a property has a low GRM does not mean it is a sure thing. Operating costs, like utilities, maintenance, management, repair costs, vacancies and other expenditures are a critical part of evaluating whether a property is profitable and has potential for investment.
Gross Rent Multiplier Examples:
Apart from stage of real estate cycle considerations, the GRM can also fluctuate depending on other factors such as location and type of property. There will, for example, likely be a consistent range in which the GRM will occur for Class A properties and a different range for Class C properties.
Class A properties that carry with them lower operational risks because they are well maintained, well located, and with higher credit tenants, will cost more to acquire relative to gross rents versus Class C properties. Similarly, the GRM will differ across cities, regions and even states enabling the investor to quickly compare opportunities outside of areas in which them have immediate familiarity. For example, a developer finding that prices have climbed to unsustainable levels in their own local market, perhaps with GRMs in the mid to high teens, might be enticed to look further at markets where the GRM still hovers in the single digits.
Why is the Gross Rent Multiplier Important?
One of the most critical steps in the commercial real estate investment process is the ability to differentiate quickly between properties to decide how much time and resources to allocate to conducting further analysis of investment opportunities. Commercial property valuations are very different than residential, and there are a multitude of factors that go into choosing a property. Property comparisons are much harder when you have to worry about building overhead and maintenance, as well as dealing with the vagaries surrounding rental income, raises, tenant issues, and everything else that comes with running a successful commercial property.
The GRM gives you the ability to quickly compare two similar properties, which may be different sizes, in different locations, or have varying characteristics warranting further quantification using other, more precise, comparison methods. As such it is an excellent way to save time searching for investment properties; instead of digging into the financials of every single property a sponsor comes across, they can find the Gross Rent Multiplier quickly and efficiently and make quick decisions on whether to look closer or to pass.
Remember that time is a sponsor’s most valuable asset- there is no way to get more of it- so every second saved in a search is another spent drilling down on properties more worthy of further examination.
Pros of GRM
- Ability to quickly compare multiple properties, in different locations with different characteristics.
- Easy to use, even for new investors.
- Useful initial screening tool when looking at large numbers of opportunities.
Cons of GRM
- Gross Rent Multiplier fails to consider operating expenses. This means that added costs like repairs are not accounted for in the calculation, which can make a property seem more valuable than it actually is.
- Similarly the GRM does not account for vacancy rates, or property taxes and insurance.
- Often erroneously understood to measure the time it would take to pay off a building.
How is a Gross Rent Multiplier Different Than Cap Rate?
Cap rate and GRM are both commonly used by real estate investors and are sometimes conflated to be the same thing – however they are very different. First of all, cap rates are based on NOI, or Net Operating Income, as a ratio against property value or price, compared to the gross scheduled income that is used in the GRM. When calculating the cap rate, the net operating income is divided by the property price rather than dividing the property price by top-line revenue as with the GRM.
The cap rate considers the majority of building operating expenses, like repairs, upgrades to the grounds and building, and utility costs. As such, the cap rate is a far superior measure of true property value than is the GRM for determining investment performance.
One caveat, as expenses are often subject to manipulation, it can be tough to accurately determine a property’s operating expenses, which makes cap rate more challenging to come to correctly when compared to GRM. Consequently, while the GRM is a quick first look metric for sponsors, the cap rate, requiring as it does greater diligence to examine accurately, is a second-tier item used to determine a more accurate picture of true value and potential.
What are the Limitations of the Gross Rent Multiplier?
As we mentioned earlier, the Gross Rent Multiplier is an excellent starting point, especially for new investors- but like any valuation method, it is by no means perfect. Real estate assets are among the hardest investments to vet property, and while the GRM can show an investor how one property compares against another, it does not tell the whole picture- not by a long shot. Potential deferred maintenance costs, troublesome tenants, hidden expenses, excessive operating costs and other liabilities associated with a property are not included in this calculation. That is why when setting out to find the right investment property, it is imperative to use other comparison methods in conjunction with the Gross Rent Multiplier as an initial screen, including, as mentioned earlier price per foot, cost per unit, rent per foot etc., before moving on to more detailed due diligence.
How to Use Gross Rent Multiplier to Narrow Your Search
As discussed, one of the most valuable ways to use GRM is as an early screening tool. Check it against other similar properties in an area and compare them against other similar high-level ratios. If one metric or other for a property seems out of the norm, it may warrant further investigation to determine why, exactly, that indicator is so variant.
Gross Rent Multiplier can also be used to compare entire cities or neighborhoods by finding their price/rent ratio. Let’s say you live in a city with a high average GRM, like many high-dollar West Coast cities such as San Francisco and Los Angeles. The median GRM in cities like that can far exceed similar cities in other parts of the country.
Remember that GRM can also make lower end properties seem more attractive than they are- they will not consider many of the issues these properties often have. This is why for any kind of property the GRM cannot be used as a defining ratio to determine value; it is only an early phase metric used to decide which properties are worthy of further research.
How GRM Differs from a Cash-on-Cash Return
Many investors also use the Cash-on-Cash return to determine the value of a property. This method is more effective than a GRM, but it also requires significantly more time and effort to determine correctly. To get the Cash-on-Cash Return, investors need to plug in their exact cash investment along with gross rent, and apply an accurate accounting of expenses. The cash-on-cash calculation also requires that the investor into account financing costs – fully amortized monthly mortgage payments – as they significantly impact cash-on-cash returns.
There are good reasons to use Gross Rent Multiplier to evaluate potential commercial properties. The ease of use makes even the newest investors able to utilize this formula to their advantage, with little risk of making mistakes as with more complicated formulas. The time savings offered by GRM are also fantastic, it only takes a few seconds to determine whether or not a property meets your GRM requirements, and you can use the technique with neighborhoods, regions, cities, or entire states.
However, this metric should be used in combination with other similarly broad and indicative ratios such as price per foot, rent per foot, gross per unit price and others, to determine if anything appears out of sync with the property type and location. Once a property has been vetted by these ‘blunt’ calculations and opportunities identified, the more sophisticated evaluation techniques commonly used in sophisticated feasibility studies will help investors to develop a clearer picture of their potential investments.
In short, the Gross Rent Multiplier is a useful tool for the investor in identifying where opportunity may exist when used with a range of other similarly broad, indicative metrics, and is helpful in identifying properties worthy of deeper investigation.