How Do I Use the Gross Rent Multiplier in Commercial Real Estate?
Introduction to the Gross Rent Multiplier
Some of the more common valuation metrics in commercial real estate, such as the application of a cap rate or building a full-fledge discounted cash flow (DCF) model, all require a decent amount of data on the property and the income of the property (especially in the case of cap rate and DCF valuation). In some cases, however, investors don’t have all the information they need to effectively value a property using one of the previous methods. One alternative to cap rates and DCF is the Gross Rent Multiplier (GRM) approach.
How is the GRM calculated?
We’ll first take a look at how GRM is calculated and then we’ll discuss how to best use it to get a better feel for the potential value of a property.
GRM = Property Value / Gross Rental Income
The Property Value variable in the formula above is self-explanatory. The Gross Rental Income variable is a bit more nuanced and is sometimes used differently by real estate professionals. Sometimes only the base rent from tenants is included in the Gross Rental Income while other times all income is included, such as additional revenue collected from laundry, vending machines, and other supplementary services the property offers. It’s important that an analyst understand which metric is being applied to ensure consistency when comparing multiple properties using a GRM approach.
How is the GRM used in practice?
As mentioned above, approaches such as cap rate and discounted cash flow (DCF) valuations are generally preferred by real estate professionals in making accurate determinations of the value of a property. But how does an investor quickly get an idea of the potential value of a property without going through all the trouble of analyzing financial statements and building DCF models? One way is to determine the relationship between the total amount of income the property is generating and the value of the property (in most cases this initially will be the asking/listing price of the property). An investor can then quickly compare the GRM across multiple properties in a fraction of the time it would take to apply the cap rate and DCF methods.
Variation of the GRM Formula
The standard GRM formula divides the value of the property by the gross income of the property, but oftentimes this formula needs to be rearranged in order to quickly determine an estimated value for a property when the value isn’t otherwise known. The rearranged formula to determine the potential value is below.
Property Value = Gross Rental Income * Gross Rent Multiplier
In this case, the Gross Rental Income can be obtained from an owner or broker and the Gross Rent Multiplier can be obtained from other comparable properties in the market. The product of the income and the GRM can give an investor a general idea of the value of the property. The ability to rearrange this formula provides some flexibility for investors to look at the relationship between income and value in several different ways.
Weaknesses of the GRM
Many people new to real estate often notice that the GRM method and the cap rate method are very similar. As we mentioned above, the GRM can often provide a much quicker way to estimate the value of a property, but it also leaves many details out of the valuation analysis that a cap rate approach includes.
The major difference in these two approaches is that the GRM uses the gross income of the property, while the cap rate approach uses the Net Operating Income (NOI) of the property. The cap rate approach, uses the amount of income the property generates after deducting operating expenses from the gross income. This additional step of deducting expenses from income reduces the potential for a difference in the level of expenses of a property to skew the value estimates. For example, the table below shows a hypothetical example of the comparison of two properties using both the GRM and the cap rate valuation methods.
As the table illustrates, the Gross Rental Income on line 2 and the GRM on line 11 are exactly the same for both properties, resulting in an estimate of valuation using the GRM method of $4,000,000 (line 12).
Additionally, line 13 shows that the cap rate applied to both properties is exactly the same. However, these two properties have a slightly different amount of utilities expenses (line 7). While this could be for several reasons, including more efficient equipment, tenants paying a different portion of the residents’ utilities, etc., figuring out why there’s a difference is irrelevant for the purpose of this example. What we do know is that there is a difference in utilities expense (line 7), which leads to a difference in the total expenses (line 9), which then leads to a difference in the net operating income (line 10) of the two properties. Applying the same cap rate of 7.0% to the net operating income of both properties leads to a difference in value of just over $71,000.
This value difference is relatively small, but for larger properties or for more variation in the expenses between two properties, the amount of the difference could grow to be significant.
Likewise, the DCF method takes the cap rate approach a bit further by not only considering the effect of vacancy and expenses, but also takes a forward-looking approach to estimate future cash flows, expenses, and any major capital expenditures that could negatively impact the overall return the investor achieves by holding the property.
Hopefully the method and the purpose of GRM now makes more sense. While GRM can be a valuable tool to quickly compare properties for potential interest, it does have meaningful weaknesses that investors and analysts need to be aware of. Before any serious consideration or valuation of a property acquisition, further analysis on the income, expenses, and tenant profiles should be performed on a property to ensure a thorough understanding of the property’s characteristics.