No More Gross Rent Multipliers!
By Steve Gillman - 2005
What is a gross rent multiplier? It is a simple formula for
determining the value of rental real estate that has been around
for ages. My first real estate investing book advised me to "never
buy a property with a GRM of more than 8." GRM is the acronym
for gross rent multiplier, and the formula is simply this: divide
the price by the gross annual rents to get the GRM.
The author was advising me to never pay more than 8 times
the annual rent for a rental property. That seemed simple. I
started looking at properties in terms of GRMs. If it was selling
for 6 times rent it must be a good deal. If it was 12 times rent
it had to be bad. It was great to have such a simple rule to
follow - except that it never was a good rule to begin with.
A gross rent multiplier is a crude way to put a value on a
property. It is just too simplistic. Suppose two buildings each
are selling for eight times their gross annual rent collections.
One however, includes all utilities in the rent that tenants
pay. That changes things, doesn't it? Of course, you could try
to subtract out the utilities, to see what rents would be if
they weren't included, and use that for the GRM. But that's not
the only problem.
You have to constantly change the GRM expectations to reflect
interest rates, because a property might be profitable at 12
times rent when interest rates are low, but a money loser at
eight times rent if the financing is expensive. Also, there are
just plain different expenses for different properties, whether
higher maintenance costs, insurance premiums, or whatever. Gross
rent doesn't say much about the factor that really makes a rental
property valuable: the net income.
Valuing With Cap Rates
We buy rental properties for the income they produce, right?
Then this is what your real estate valuation should be based
on. That is why you need to how to use a capitalization rate,
or "cap rate" to determine value. A cap rate is the
rate of return expected, or the rate of return on a property
at a given price.
A simple example will make this clear. Start with the gross
income of a property and subtract all expenses, but not loan
payments. Suppose the gross income is $80,000 per year, and the
expenses are $34,000, you have net income before debt-service
of $46,000. To arrive at an estimate of value, apply the capitalization
rate to this figure.
Now suppose the normal capitalization rate is .10 in your
area, meaning investors expect a 10% return on the value of their
investment. You can use your own rate, of course, but if others
are paying more you may have a tough time buying anything. Now
divide the net income of $46,000 by .10, and you get $460,000
- the estimated value of the building. With a cap rate of .08,
meaning an 8% return, the value would be $575,000.
To see what the cap rate is based on the asking price of a
property, just divide the net income by the asking price. For
example, if a seller wants $675,000 for a property, and the net
income is $55,000 you would divide 55,000 by 675,000. This gives
you a cap rate of .81.
Property value equals net income before debt-service divided
by cap rate. This is a simple formula, but the tough part is
getting accurate income figures. Be sure the seller gives you
ALL the normal expenses, and doesn't exaggerate income. Suppose
he stopped repairing things for a year, and is showed "projected"
rents, instead of actual rents collected. The income figure could
be $15,000 too high, which would cause you to estimate the value
at $187,000 more (.08 cap rate). Ouch!
Smart buyers sometimes separate out income from vending machines
and laundry machines. If these sources provide $6,000 of the
income, that would normally add $75,000 to the appraised value
(.08 cap rate). However, you can do the appraisal without including
this income, and then add back the replacement cost of the machines,
which is probably much less than $75,000.
Another consideration: if you are competing to buy properties
based on the same cap rate used by others, but you have to borrow
at higher interest rates or buy with less of a down payment,
you could have cash flow problems. Don't let formulas get in
the way of thinking through all the factors. No simple valuation
formula is perfect, and all are only as good as the figures you
plug into them, but using cap rates to figure value is certainly
better than using gross rent multipliers.
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