Real estate investments are tangible assets that can lose value for many reasons. Thus, it is important that you value an investment property before buying it in order to avoid any fallouts. Successful real estate investors use various valuation methods to value an investment property and these include Gross Rent Multiplier (GRM), Capitalization Rate, Cash on Cash Return, among others. Each and every real estate valuation method analyzes the performance using different variables. For example, the cash on cash return measures the performance of the cash invested in an investment property ignoring and not accounting for a mortgage, per se. Capitalization rate, on the other hand, can be more beneficial for income generating or rental properties. This is because capitalization rate measures the rate of return on a real estate investment property based on the income that the property is expected to generate.
What about the gross rent multiplier? And what is its significance in real estate investments?
In this article, we will explain what Gross Rent Multiplier is, its significance and limitations. To give you a better idea of Gross Rent Multiplier, we will compare it to another property valuation method, capitalization rate or “cap rate.”
What Is Gross Rent Multiplier?
Similar to other property valuation methods, Gross Rent Multiplier becomes effective when screening, valuing, and comparing investment properties. As opposed to other valuation methods, however, the Gross Rent Multiplier analyzes rental properties using only its gross income. It is the ratio of a property’s price to gross rental income. Through top-line revenue, the Gross Rent Multiplier will tell you how many months or years it takes for an investment property to pay for itself.
GRM is calculated by dividing the fair market value or asking property price by the estimated annual gross rental income. The formula is:
GRM= Price/Gross Annual Rent
Let’s take an example. Let’s assume you aim to buy a rental property for $200,000 that will produce a monthly rental income of $2,300. Before we plug the numbers into the equation, we want to calculate the annual gross income. Beware! So, $2,300*12= $27,600. Now we have all the variables necessary for our equation.
Gross Rent Multiplier = Property Price/ Gross Annual Rent = $200,000/$27,600 = 7.25.
The Gross Rent Multiplier is thus 7.25. But what does that mean? The GRM can tell you how much rent you will collect relative to property price or cost and/or how much time it will take for your investment to pay for itself through rent. In our example, the real estate investor will have an 87-month ($200,000/$2,300) payoff ratio which translates into 7.25 years. That’s the Gross Rent Multiplier!
Related: How to Value an Investment Property
What Is a Good Gross Rent Multiplier?
In our previous example, the GRM came out to be 7.25 years. You might wonder, is this a good rate? Certainly. The lower the GRM, the better. This means that your rental property will take less time to pay off its property price. Typically, you want your Gross Rent Multiplier to range from 4 to 7. Think about it, you want to get as much rent as you can for the least cost.
Related: Cap Rate vs. Gross Rent Multiplier: Advantages and Disadvantages
When calculating GRM, it is important to assess repair fees that may arise and take them into account. Often times, real estate investors buy rental properties for too cheap that also have a low GRM. However, they neglect the fact that repairs done to investment properties as such might leave you with more years to pay off the property price. Don’t always go for too cheap properties. We recommend that you compare GRM across various investment properties within a location. As a matter of fact, the GRM is best used when compared to other GRMs for similar properties within a real estate market.
What Are the Pros and Cons of Using Gross Rent Multiplier?
Pros
- It is easy to use.
- To calculate the Gross Rent Multiplier, you need to account for gross rental income. Since rental income is market-driven, GRM makes a reliable real estate valuation method for comparing investment properties.
- It makes an effective screening tool for potential properties: this tool allows you to compare and contrast several properties within a real estate market and conclude on a property with the most promise as far as price and rent collected.
Cons
- The GRM fails to account for operating expenses. One investment property might have as high as 12 GRM, however, incurs minimal costs, while another investment property might have a GRM of 5 and has incurred costs to exceed 5% of property price. Note that older properties might sell for lower and thus have a lower GRM. However, they tend to have higher expenses. Therefore, when accounting for expenses, the number of years to pay back the property price will be higher. Because the GRM considers only the gross income, GRM fails to differentiate investment properties with lower or higher operating expenses.
- The GRM does not account for insurance nor property tax. You might have two properties with the same property price and rental income but different insurance and property tax. This means that when accounting for insurance and property tax, the amount of time to pay off property price will be higher than the GRM.
- Since the Gross Rent Multiplier uses only gross scheduled rents as opposed to net income, it fails to enumerate and calculate for vacancies. All investment properties are expected to have vacancies; in fact, poorer performing real estate investments tend to have higher vacancy rates. It is important that real estate investors differentiate between what an investment property can bring in and what it actually generates, of which GRM does not account for.
What Is the Difference Between Cap Rate and Gross Rent Multiplier?
Many real estate investors confuse cap rate and GRM. We will sort this out for you. First and foremost, the cap rate is based on the net operating income rather than the gross scheduled income as calculated in GRM. So for the cap rate equation, instead of dividing property price by top-line revenue as done in the GRM measurement, we divide net operating income (NOI) by property price. What is different in the cap rate from GRM is that cap rate takes into account most of the operating expenses including repairs, utilities, and upgrades. Some real estate investors might think that cap rate makes a better indicator of the performance of an investment property. However, note that often times expenses can be manipulated, as it might be difficult to estimate a property’s operating expenses. Therefore, we can conclude the cap rate is more difficult to verify as opposed to GRM.
Related: Here Is Everything You Need to Know About Real Estate Property Market Analysis
To sum up, the Gross Rent Multiplier is a real estate valuation method to assist you when screening for potential investment properties. It is a good rule of thumb to help you analyze a property and select from potential real estate investments. Keep in mind that the GRM does not account for operating expenses, vacancies, and insurance and taxes. Make sure to factor these expenses in your investment property analysis. For more information about Gross Rent Multiplier or other valuation methods, visit Mashvisor. As a matter of fact, Mashvisor’s rental property calculator can help you with these calculations.
At Mashvisor, we take pride in helping you and all real estate investors understand how much to pay for a particular investment property so as to bring about a positive cash flow. To learn about your options for signing up for our services, click here.
