What is a gross rent multiplier? |Why is the GRM important? |How to calculate the GRM | What is a good GRM? | Pros & cons of the GRM | Gross rent multiplier vs. cap rate
Have you ever found multiple promising properties at once? Wished for a quick and easy way to compare them without having to run a full analysis? The gross rent multiplier (GRM) might be exactly what you’ve been looking for.
It’s a simple formula that investors use to compare and contrast rental property values, and it can help sort desirable properties from less profitable counterparts. You can use GRM as a preliminary filter to determine which properties are worthy of a deeper financial analysis.
Read on for a breakdown of how to use the gross rent multiplier and why it’s a great tool in real estate.
What Is A Gross Rent Multiplier (GRM)?
The gross rent multiplier (GRM) is a formula used by real estate investors to compare the potential rental income of different properties. This valuation technique is a simplified way to analyze properties without conducting a complete analysis. Real estate investors of all skill levels rely on this formula to quickly compare properties across portfolios and make fast-paced investment decisions.
It is worth noting that the GRM is not to be used in place of thorough property analyses. Instead, it is best used to eliminate properties before performing in-depth analyses of promising candidates.
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Why Is The GRM Important In Real Estate?
The GRM is important to real estate investors because of its speed and utility. The formula utilizes two variables: rental property value and gross property income. There are several formulas in real estate investing, but almost none are as simple as the GRM. Investors typically have access to both numbers and can easily perform this calculation. These also happen to be the variables that lenders care about the most when evaluating potential investments (price and potential return). In calculating the GRM, investors get their first look at the factors they may present to lenders when raising financing.
The GRM is also particularly beneficial for commercial real estate investors who may be working in highly competitive environments. Commercial real estate often requires investors to be able to make fast-paced decisions about where to delegate their time and resources. The GRM can be quite an effective tool in doing so, as it allows users to easily compare potential investments.
Gross Rent Multiplier Formula
Calculating the gross rent multiplier is simple. You take the market value of a property and divide it by the property’s gross rental income. How you do this is up to you: you can use the sale price, list price, or property appraisal value. You can even choose between monthly or annual income. When using the gross rent multiplier formula, you’ll want to make sure to keep the factors consistent across all the properties you are considering. Otherwise, any comparisons you make will be invalid.
It can be helpful to practice with an example. Let’s say you found a rental property with a list price of $500,000, and based on your estimate, the gross annual income is $80,000. In this case, your GRM is 6.25 (500,000 / 80,000). Then, you’ll continue to make similar calculations with other properties that you’ve identified. You’ll run a gross rent multiplier appraisal and look for properties with the lowest possible GRMs. (Obviously, you’ll want properties that produce more income. The larger the denominator, the smaller the resulting number will be.)
Keep in mind that the GRM is best used to compare the potential income between properties. It cannot predict how long a specific loan will take to pay off, which property will have fewer expenses, or the amount of debt associated with purchasing a given property. Each of these factors will need to be considered during a more thorough property analysis.
Using The GRM To Estimate Property Value
GRM can also estimate the property value of an investment you are considering. If you ran the gross rent multiplier formula for a few properties and found an average, you could use that number alongside the annual rental income. Together, these variables would allow you to reverse calculate the property value. This exercise would allow you to compare the market value of a property against its sale price, especially if the purchase price changed. For example, if the GRM is around 7% and the rental income is $75,000 this property value would be $525,000. Suppose that same property is currently listed at $600,000. In that case, you could either choose to walk away from the property or conduct a more thorough analysis to negotiate the purchase price in your favor.
How To Use GRM In Real Estate Investments
Let’s take a look at how a real estate investor would use GRM.
First, gather a list of prospective properties you’re interested in. Be sure you know the rental property value and gross property income for each of them. Then, calculate the GRM for each property using the provided formula.
Let’s say that one property has a GRM of 7, while the other two properties in the same area have a GRM of 9 and 10. The property with the GRM of 7 preliminarily appears to be the most profitable opportunity. You would proceed with a deep analysis of this property to decide if it’s a worthy investment.
More Examples Of GRM In Real Estate
The GRM formula is made up of three variables: Gross Rent Multiplier, Rental Property Value, and Gross Property Income.
You don’t always have to use this formula to calculate GRM. If you know two out of the three variables, you can calculate any of the variables in the formula.
For instance, you can reverse-engineer the formula to calculate gross rental income. Let’s say that the average GRM in a neighborhood is 6, and the asking price of the property is $300,000. You can deduce that the gross rental income is $50,000. This is how the calculation is made:
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Gross Rent Multiplier = Rental Property Value / Gross Rental Income
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Gross Rental Income = Rental Property Value / Gross Rent Multiplier
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Gross Rental Income = $300,000 / 6
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Gross Rental Income = $50,000
Manipulating these formulas allows investors to analyze properties quickly before they zero in on one or two promising candidates.
What Is A Good Gross Rent Multiplier?
A good gross rent multiplier in real estate is typically one of the smaller numbers within your range. As I mentioned above, this is because a lower GRM generally suggests more rental income in relation to the purchase price. That being said, there is not a universally “good” GRM; that definition will always have to be established when looking at your specific calculations. What I mean by this is this month, you could look at properties with an average GRM of 4 to 5, but next month that number could be between 7 and 8. The gross rent multiplier is all about comparison.
What Is A Good GRM For A Rental Property?
Typically, a GRM between 4 – 7 is considered “good” for a rental property. Again, it is important to note that a healthy GRM is dependent on your local market and the comparable properties within that market. The lower you can make your GRM, the less time you will need to pay off your rental property’s purchase price. To achieve this, you must generate the most rental income you can with the least cost.
Pros & Cons Of The Gross Rent Multiplier
The gross rent multiplier has several advantages, but there are some drawbacks to consider. Keep reading as we pick apart the GRM and what the great advantages and potential downsides are so that you can be mindful when you add it to your investor toolbox.
Pros Of The GRM
The gross rent multiplier equation is a reliable formula for some of today’s best real estate investors, and there are many reasons why. Read through the following benefits to understand why you should add the GRM to your repertoire today:
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Unique to rental properties: The gross rental multiplier is a formula that is unique to rental property valuation.
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Quick and easy: The formula is easy to use, and doesn’t require any in-depth calculations or analysis.
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Rate of return calculator: The GRM in real estate is a way to calculate the rate of return on rental properties.
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Benchmark several properties at once: Comparing and contrasting multiple rental properties at once would be quite an undertaking, but luckily, this powerful formula allows you to compare more than one property so that you can determine which ones are worth further exploring.
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Establish a threshold: Once you’ve used the GRM in your analyses several times, you’ll start developing your own threshold for what rate of return you’d find acceptable, and you’ll be able to establish a grading system for rental properties.
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Keep a pulse on a market: Finally, the gross rent multiplier can be a nifty tool to keep a pulse on a rental market. You can calculate the GRM for a few properties within a market and keep track of whether the GRMs on those properties increase or decrease over time.
Cons Of The GRM
Like with any real estate evaluation, there are potential downsides to using the GRM. However, most of these cons can be mitigated with a little due diligence. Review the following drawbacks to learn more:
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Does not consider all costs: As mentioned above, GRM is calculated using top-line revenue, or gross income. This means that it does not factor in any costs of running a rental property, such as operating expenses, vacancy rates, or the cost of insurance or taxes. Here’s a great breakdown of how to quickly estimate rental property expenses.
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Accuracy not guaranteed: Because the GRM does not account for property costs, some will argue that it does not paint an accurate picture of the return on investment. When you think you’re comparing apples to apples in a certain market, what you don’t know is that one property may have more operating expenses than the other. That’s why it’s good to use the GRM only as an initial screening tool. Always be sure to perform a more in-depth analysis once you’ve narrowed down your search to several properties.
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May cause you to overlook a good property: If you use a certain tool or calculation as a screening tool, the main danger is the potential to overlook a great property. If you’re quickly filtering through a long list of properties and only looking at certain indicators, you run the risk of skipping over a diamond in the rough just because the initial financials didn’t look good or pass your grading system.
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Gross Rent Multiplier Vs. Capitalization Rate
Gross rent multiplier and capitalization rate are two invaluable tools used by today’s real estate investors. While both have proven useful, some find it easy to confuse the two.
Both are used to evaluate income-producing properties based on the amount of rental income they can generate. It’s not hard to see why people would mix the two up.
Relationship Of Cap Rate To The Total Return
The capitalization rate, or cap rate for short, calculates property returns by comparing the net operating income (NOI) with the home’s current market value. More specifically, it can evaluate how profitable an income property will be relative to its purchase price. Doing so takes into account the property’s operational expenses and its vacancy rate. Cap rate indicates whether generated income will cover the mortgage.
Some think that cap rate is a better formula than GRM because it accounts for all costs, but keep in mind that costs can be manipulated. In contrast, GRM measures the ratio between the asset’s gross scheduled income and its fair market value. This tool will tell you how much income a property will generate, but doesn’t account for all expenses. This is why GRM is typically used as a preliminary filtering system, followed by additional formulas such as NOI and cap rate when running a deeper analysis on a promising property.
Example of Calculating Cap Rate Vs. GRM
An example of calculating cap rate can help demonstrate how the formula paints a different story from GRM.
Earlier, we used an example property that had a property value of $300,000 and gross rental income of $50,000 and using the 50% Rule, we estimate that the property’s net operating income (NOI) is $25,000. (Half of the gross rental income used to pay operating expenses, not including the mortgage payment.)
To calculate cap rate, we simply divide the property’s NOI by the property value:
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Cap Rate = NOI / Property Value
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Cap Rate = $25,000 / $300,000
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Cap Rate = 0.0833 or 8.3%
In this example, the Cap Rate is 8.3 percent. Similar to GRM, this data point from a single property doesn’t mean very much. However, you can compare this same data point across multiple properties in the same area to identify which property is a better deal because the potential return is relatively higher.
Note that a potentially profitable property will show a relatively higher cap rate and a relatively lower GRM (in comparison to other properties.) An example comparing a property’s cap rate and GRM before and after a rent hike can help illustrate this point.
The same example property with a property value of $300,000 and NOI of $25,000 will have a rent increase of 5%.
Before the rent increase:
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GRM = $300,000 Property Value / $50,000 Gross Rental Income = 6
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Cap Rate = $25,000 NOI / $300,000 Property Value = 8.3%
After a rent increase of 5%, gross rental income increases from $50,000 to $53,000 and the NOI increases from $25,000 to $26,500:
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GRM = $300,000 Property Value / $53,000 Gross Rental Income = 5.7
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Cap Rate = $26,500 NOI / $300,000 Property Value = 8.8%
As you can see from this example, the GRM decreased while the Cap Rate increased after a rent hike. Both indicate an improvement to the financial optics on the same property. Keep this in mind as you incorporate both formulas into your deal analysis toolkit.
Other Ways To Evaluate Real Estate Investments
When evaluating your real estate investments, it’s always a good idea to have several helpful calculations memorized. You should never rely solely on one type of calculator or benchmark. Instead, you should run several sets of calculations to evaluate properties from multiple angles. We already discussed the difference between the GRM and cap rate, which is an investor favorite. There are also indicators such as cash flow, rental yield, and internal rate of return. Be sure to check out our guide that breaks down several rental property calculations you should know.
Summary
The best way to think of the gross rent multiplier is as a grading system. By using consistent variables, investors can quickly compare multiple properties. And although the GRM doesn’t factor in the costs associated with property ownership, it can still be a great initial, large-scale screening tool. This is particularly important to remember for those who plan on breaking into commercial real estate.
If you ever happen to find yourself at the hands of too many deals, this formula can be a great way to eliminate properties that do not hold much promise. This will leave you with the time (and energy) to closely examine properties that could add more value to your portfolio in the long run.
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