Most people will look at several real estate deals before opting to invest in any. This analysis provides an investor with background about what’s a “good” versus a “bad” deal. At least in terms of potential profitability.
Investors who are just beginning may find it challenging to determine which opportunity has the greater potential for profitability. There are some basic tools an investor can use. Example such as cap rates to conduct a quick apples-to-apples comparison of investment opportunities.
One of those often used tools is the gross rent multiplier. In today’s article, we look at how to calculate the GRM. We will also discuss why this is a valuable metric for investors to consider when weighing all deals.
What is Gross Rent Multiplier?
Investors use the gross rent multiplier, or “GRM,” as a tool to estimate the potential return they could earn on a particular investment property. The GRM is the ratio of the annual rent to the value of the asset before accounting for expenses such as insurance, utilities and property taxes.
The “Income Approach”
The GRM is considered a form of the “income approach” to appraisal. The income approach to property appraisal is used to determine the value of income-producing properties (vs. trying to determine the value of an owner-occupied residential property, which uses different appraisal approaches).
Appraisers can also use GRM, especially when determining the value of small income-generating properties like 2- to 50-unit apartment buildings.
The GRM helps provide a single factor of comparison based on sale price and rent generated which is more valuable information for investors versus looking at sales comps alone (which might be more useful when shopping for traditional residential properties). After all, most investors care more about how much rent they can generate than sales price (or price per square foot) alone—a property with a lower value but minimal income is not as valuable as a property worth slightly more that has a track record of high rent collections.
The gross rent multiplier (GRM) is the ratio of the annual rent
to the value of the asset before accounting
for expenses such as insurance, utilities and property taxes.
In other words, if an investor is looking in a marketplace and there are several different rental properties that sold for different numbers and each is bringing in a different rent, what the GRM allows someone to do is compare many rental properties against one another by using one simple metric: GRM.
What is the Formula for Gross Rent Multiplier?
Calculating the GRM is pretty straightforward. An investor only needs two inputs: property value and gross annual rent.
To be sure, the property value is not the same as the asking price. Instead, it is the appraised value or the selling price for the property.
Investors should use the gross annual rent, which represents the total rent collected during a year, to ensure accurate calculations, rather than the gross monthly rent. The gross rent does not include expenses, nor does it factor in vacancy or collection losses.
Here is an example:
Let’s say a property sells for $1.2 million. The gross annual rent is $120,000. The gross rent multiplier is 10, in this case ($1.2 million / $120,000 = 10).
Now let’s compare that property to two others. Property No. 2 sells for $1.5 million and has a gross annual rent of $170,000. The GRM for Property No. 2 is 8.8. Property 3 sells for $2.1 million and has a gross annual rent of $310,000. In this case, the GRM for Property No. 3 is roughly 6.8.
So, while on the surface, it may seem like Property No. 1 is the best “deal” since it only costs $1.2 million, investors who are concerned about cash flow may be more interested in the other properties, especially Property No. 3, since it has a lower GRM. Property No. 3, for example, costs almost double, but it generates in excess of double the rents each year as well – making Property No. 3 the most lucrative of the three properties compared on a gross rent basis alone.
What is a “Good” GRM?
Determining what a “good” gross rent multiplier is largely depends on the properties being compared. For example, in the analysis above, the property with the GRM of 6.8 would be said to have a “good” GRM relative to the other two properties. If this same property were compared to ten other properties, however, the investor might find that a GRM of 6.8 is really only middle-of-the-pack and that there are other deals out there that are potentially more profitable.
Needless to say, most investors will agree that a GRM in the mid-single digits is excellent. A GRM in the upper single digits is still strong, and anything in the double digits starts to become more concerning (or at least, deserving of a more in-depth analysis.
This also means that GRM tends to have an inverse relationship with property classes. Class A properties, which tend to be more expensive and highly sought after properties (i.e., “trophy assets” or “institutional assets”) will generally have a higher GRM than Class B or Class C properties, which tend to have a lower value – one of the key inputs into the GRM calculation.
Why Investors Should Use Gross Rent Multiplier
Investors often use gross rent multiplier as a way for screening and conducting an initial analysis of properties. It is a way of conducting an apples-to-apples comparison of properties across asset classes and geographies. For example, an investor who is otherwise agnostic to property type may look at the GRM associated with a multifamily property, an office building, and a retail center and decide which to invest on based on which property generates the “best” GRM. Assuming that a lower GRM is a better investment opportunity.
Investors often use gross rent multiplier as a way for screening and conducting an initial analysis of properties.
Some investors use the GRM as a way to estimate how many years it would take for the investment to pay for itself.
For instance, a $1.2 million property that generate $120,000 in monthly rent could approximately take 10 years to fully pay off. Of course, this is a simplification because other expenses must be taken into account. Such as repayment of debt, which would add to that time horizon.
Investors who want to compare and choose investment properties where costs, either in absolute terms or as a percentage of gross rental income, are similar across properties, find GRM most helpful. Investors may also use GRM when costs are expected to be negligible compared to gross rental income.
Since it is usually easier to predict market rental returns than costs. Investors sometimes use GRM when the information about expenses is scarce. In situations like these, the true gross rent numbers may also be missing (e.g., a seller may not provide an updated and/or accurate rent roll), but some simple market research can often provide sufficient detail about what gross rents should be based on local comps.
As with any analysis of comparable properties, the more properties compared using the GRM, the better the results will be.
Using GRM to Estimate Property Value
Investors who want to estimate a property’s value can also use GRM. Investors often need to do so when they are analyzing off-market deals. Or when bidding on a property listed for sale by a broker without an asking price. In these situations, the seller may ask buyers to come forth with their “best” offer without any baseline for what the seller is expecting to receive.
This is when GRM can come in handy.
An investor looking to estimate what a property is worth can use the GRM for this calculation:
Gross Annual Rent x GRM = Estimated Property Value
Of course, without knowing the sales price, it is difficult to calculate the GRM. Instead, an investor can use the GRM from local comps as a baseline. The investor will want to weigh the GRMs based on which property is most similar to the one they are looking to purchase. Then, using that estimated GRM, the buyer can come up with an estimated property value.
For example, if a property generates $225,000 in gross annual revenue. Where as comps from similar properties have an average GRM of 7.5. Then an investor might determine that the rough value of the subject property is $1,687,500 (or $225,000 x 7.5).
The Downsides of Using Gross Rent Multiplier
While the GRM is a useful tool for those looking to do a quick analysis of properties. It should only be used as a very preliminary screening tool. In reality, the profitability of an asset will largely depend on more than the purchase price and gross rents. Consider expenses, which play a crucial role in determining the profitability of an investment.
Here is a more detailed look at some of the shortcomings of GRM.
- GRM does not account for appreciation or depreciation in future value. It assumes that the sales price, or appraised value, will hold constant during the lifetime of the hold period. Although real estate values don’t experience dramatic swings in the short-term. There are unexpected events (like the Great Recession or COVID-19) that can suddenly affect values. Moreover, an investor with a long-term buy and hold strategy will almost certainly experience a change in value during the hold period. Most property tends to appreciate with time.
- GRM does not measure total operating income (i.e., net operating income). Instead, GRM looks solely at gross annual rents. It’s not unusual for properties to have multiple income streams, and GRM overlooks the value of those income streams. For example, two properties selling for the same amount with the same monthly rent may have different values if one of those properties collects ancillary income from laundry, parking, storage fees, amenity fees, utility reimbursements and the like.
- GRM does not factor in expenses. In addition to operating expenses as mentioned above. There are other costs an owner will incur. Ranging from taxes to insurance, vacancy and credit losses, capital improvements and more. For example, two otherwise similar properties may have different degrees of profitability. If one is located in an area with high property taxes compared to one with low property taxes.
- GRM ignores leverage. Investors usually buy investment property using leverage, such as a bank loan or mortgage. The cost and terms of the debt can vary widely depending on the nature of the deal. For example, a fully-stabilized property located in a core market might qualify for a lower rate than a value-add property located in a secondary or tertiary market. The cost of debt can have a major impact on a deal’s profitability.
Gross Rent Multiplier vs. Gross Income Multiplier
People often confuse GRM with the gross income multiplier, also known as GIM. The key difference between the two is that the GRM looks solely at the value of annual rents collected. Whereas the GIM factors in other sources of annual income (above and beyond rent alone). The GIM may include extra income from things like parking, laundry or storage fees.
Gross Rent Multiplier vs. Cap Rates
GRM and cap rates are both used to measure the value of an income property. The primary difference is cap rates are calculated by dividing net operating income by market value. Like GRM, cap rates tend to have an inverse relationship with property value as well. The more valuable the property, the lower the cap rate and vice versa.
Benefits of Cap Rates
The benefit to using cap rates instead of GRM is that the cap rate uses income generated after factoring in expenses (the NOI). This is often considered a more precise gauge of the monthly or yearly cash flow that a property will generate. However, it can be difficult to calculate the cap rate absent reliable information about a property’s operating expenses, in which case GRM can be a useful substitute when comparing properties.
The gross rent multiplier, while not a perfect metric. Is one that can prove especially handy to investors looking at dozens, even hundreds of deals at a time.
It is one of those tools that can be used for initial screening purposes. Then if a deal meets an investor’s GRM threshold. An investor can dig deeper to determine whether or not more detailed underwriting is worthwhile.
While the GRM is a useful tool for those looking to do a quick analysis of properties, it should only be used as a very preliminary screening tool.
Ultimately, GRM is just one of several tools available to investors when evaluating investment opportunities. There are many ways to slice and dice a deal. The more information a prospector investor has. The more informed decision he or she will be able to make about whether to proceed.
Interested in learning more about Smartland’s investment strategy? Contact us today.