Trying to determine which rental property is the better investment can be incredibly confusing, especially if you are just beginning to invest in real estate. Fortunately, there are several key financial metrics you can use to help decide which income-producing property is better than the rest.
Gross rent multiplier is a calculation that both beginning and experienced real estate investors use to select the best rental properties to invest in and to monitor the real-time financial performance of property they currently own.
In this article, we’ll explain how you can use gross rent multiplier to choose the right investments, why the metric is different from cap rate, and the best ways to use the gross rent multiplier calculation when you invest in real estate.
What is Gross Rent Multiplier?
Gross rent multiplier (GRM) is an easy calculation used to calculate the potential profitability of similar properties in the same market based on the gross annual rental income.
The GRM formula is also a good financial metric to use when market rents are rapidly changing as they are today.
In some ways, the gross rent multiplier is similar to running fair market comparables based on the rental income a property is currently – and could be – generating when the rents are raised to market.
How to Calculate Gross Rent Multiplier
The formula for calculating the gross rent multiplier looks like this:
- Gross Rent Multiplier = Property Price or Value / Gross Rental Income
To explain how to calculate the gross rent multiplier ratio we’ll use a small three-unit multifamily property as an example. If the property produces a gross annual rent of $43,200 and the asking price for the property is $300,000 per unit, the GRM would be 6.95:
- $300,000 Property Price / $43,200 Gross Rental Income = 6.95 GRM
Taken by itself, a GRM of 6.95 is neither good nor bad, because there is nothing to compare it with. But generally speaking, a good rule of thumb many investors use is the lower the GRM is compared to other similar properties in the same market, the more attractive an investment is. That’s because the property is generating more gross income to pay for itself at a faster rate compared to alternative properties.
Other ways to use the GRM calculation
You can also use the GRM calculation to determine what the property price should be or what the gross rental income of a property should be, as long as you know two of the three variables in the formula.
For example, let’s say the market GRM is 7.5 for similar properties in the same market. If the asking price of the property is $400,000 the gross rental income should be $53,333:
- Gross Rent Multiplier = Property Price / Gross Rental Income
- Gross Rental Income = Property Price / Gross Rent Multiplier
- $400,000 Property Price / 7.5 Gross Rent Multiplier = $53,333 Gross Rental Income
If you know the market GRM and the gross rental income the property generates, you can also use the gross rent multiplier formula to calculate what the property value is:
- Gross Rent Multiplier = Property Value / Gross Rental Income
- Property Value = Gross Rental Income x Gross Rent Multiplier
- $53,333 Gross Rental Income x 7.5 Gross Rent Multiplier = $400,000 Property Value
How GRM is Different from Cap Rate
While GRM is used to estimate rental property value based on the gross rental income generated, the capitalization rate (cap rate) calculation is used to determine what property value currently is or should be based on the net operating income (NOI) returned to an investor.
Remember that NOI only includes normal operating expenses, and not the mortgage payment (P&I) made on the property. Debt service is excluded from the cap rate calculation to help make an apples-to-apples comparison, because one real estate investor may use more or less leverage than another.
Example of calculating cap rate
Let’s use the property from the previous section to calculate cap rate.
Based on the 50% Rule, we know that half of the gross rental income is used to pay for operating expenses (excluding the mortgage payment). That means that if the property has a gross rental income of $53,333 per year, the NOI is about $26,667.
To calculate the cap rate, we divide the NOI by the value of the property or purchase price:
- Cap Rate = NOI / Property Value
- $26,667 NOI / $400,000 Property Value = 0.066 or 6.7%
As with the GRM, the cap rate doesn’t mean anything by itself. However, if similar properties in the same market have a cap rate of 6%, the property with a higher cap rate could be the better deal because the potential return is higher.
GRM vs. Cap Rate
Note that cap rate and GRM present potential value in different ways.
With the cap rate calculation, the higher the cap rate is the more potentially profitable the property will be. With the GRM calculation, the lower the GRM is the more potentially profitable the property could be.
To illustrate this point, we’ll look at an example before and after the rents are raised by 6%:
Before rent increase
- GRM = $400,000 Property Value / $53,333 Gross Rental Income = 7.5
- Cap Rate = $26,667 NOI / $400,000 Property Value = 0.067 or 6.7%
After rent increase
After the rents are raised, the gross rental income increases by 6%, from $53,333 to $56,533 and the NOI (based on the 50% Rule) increases from $26,667 to $28,267:
- GRM = $400,000 Property Value / $56,533 Gross Rental Income = 7.08
- Cap Rate = $28,267 NOI / $400,000 Property Value = 0.0707 or 7.1%
Best Uses for Gross Rent Multiplier
GRM is a good calculation to use to value the gross income stream a property is generating. While the fair market value of two comparable properties might be $300,000 each, the one with the lower GRM could offer the most value because the gross rental income stream is larger.
Gross rent multiplier is also useful in monitoring changes in property value based on gross rents.
For example, let’s say your property has a GRM of 7 and similar properties nearby have a GRM of 7.5. That’s an indication you’re collecting very good rents and your property manager is doing a great job with keeping tenant turnover low with a minimal loss of rental income.
On the other hand, if your GRM is higher than other similar properties, it’s an indication that you should probably raise the rents because your gross rental income is lower than the competition.
The odds are you won’t lose any tenants because all you’re doing is raising your rents to market. If you do, you should be able to quickly find a new tenant willing to pay the market rent, because other landlords are charging the same monthly rent.
Advantages and Drawbacks of GRM
There are several pros and cons to be aware of when using the gross rent multiplier:
Advantages of GRM
- Easy back-of-the-napkin calculation to compare similar properties in the same market.
- Quick formula that beginning rental property investors can use to value rental property.
- Good screening tool for determining which real estate investment options offer the most potential opportunity.
- GRM focuses on the rental income generated rather than property price, price-per-square-foot, or price per unit.
- Both sellers and buyers can use the gross rent multiplier to value rental property. For example, a seller with a completely updated property rented to great tenants may have a higher asking price and a lower GRM. Buyers looking for a good deal will look for property with a lower GRM because the price may be below market or the gross rental income higher.
Drawbacks of GRM
- The biggest disadvantage to the gross rent multiplier calculation is that the formula doesn’t factor in operating expenses.
- Because of this, a property with a low GRM may not be as attractive an investment as it seems, if there is a significant amount of deferred maintenance.
- GRM also does not take into account lost rental income due to vacancies due to normal tenant turnover or a poorly maintained property taking longer than normal to rent.
- Some investors think that GRM measures the time it takes to pay for a property when in reality GRM only compares the gross rental income generated to the property value.