If you’ve spent more than a few minutes learning about real estate, you’ve probably heard the “gross rent multiplier” tossed around a few times.
By the end of this article, you’ll know exactly what it is and how to use it.
- Definition: Gross Rent Multiplier
- What is the Gross Rent Multiplier Method?
- Gross Rent Multiplier Formula
- How DO You Use the Gross Rent Multiplier?
- How to Calculate the Gross Rent Multiplier
- How It’s Related to other Rules of Thumb
- Consider the Pros and Cons Before Using the Gross Rent Multiplier
Definition: Gross Rent Multiplier
Gross Rent Multiplier is the ratio of the sale or purchase price of a real estate deal to its annual rental income before deducting operating costs such as utilities, taxes, insurance, etc.
What is the Gross Rent Multiplier Method?
Though the Gross Rent Multiplier (GRM) may loosely fall under the ‘income approach’, it is not the method that professionals use to create accurate estimates of fair market sales prices.
The Gross Rent Multiplier method is a simplistic way of analyzing rental property values using only its gross rental income. There are a lot of flaws associated with this method, which I’ll get into later, but it is also useful for many applications.
The Gross Rent Multiplier is one tool an investor can use when analyzing investment property. It is designed to be a very rough and quick valuation tool to determine if a property is worth your time or not.
Gross Rent Multiplier Formula
The GRM formula is very simple and easy to calculate.
So, you will take the price (sale price or asking price) and divide it by the gross rent.
If the asking price for a property is $250,000 and it has gross rents of $40,000 per year, the GRM is 6.25.
An alternate form of the formula is also very useful for identifying potential investment property:
How DO You Use the Gross Rent Multiplier?
Assuming you can calculate what an average Gross Rent Multiplier in your area is, you simply find a potential investment, and use the formula to determine if the deal is worth using the second formula I listed above.
GRM is generally used on residential multifamily properties over 4 or 5 units or commercial buildings. I will iterate multiple times that it is NOT an accurate representation of price, It is a rough estimate only.
Being a rough estimate does not mean there is no use for it. If there was no use then nobody would use it! The key is to find out how to use a gross rent multiplier and how it can help you find potential deals. Again, check out this article if you want to learn more about analyzing rental property,
Why Should I Use It?
- It’s simple
- Saves time
- Uses information that is easy to obtain
It’s an easy, time-saving method. You know that I’m all about saving time and making passive income!
The best use for the gross rent multiplier is as a filter when searching for potential investment properties. We know the GRM is not accurate, but when searching through a pile of 50 properties, who needs accurate? I may just need to sift out 30 properties real fast. By using it to filter some potential deals, you may save yourself hours or even days worth of work.
Additionally, many properties don’t list every expense in their public listing. Since it will take a considerable amount of time to contact each seller and get the detailed expense report, you can use the available information of rents to estimate value. GRM gives you a way to estimate the price without having all the pieces of the puzzle that you will need.
Reasons to Avoid the Gross Rent Multiplier
Simply – It is not an accurate measurement of price.
Gross Rent Multiplier does not take into account any expenses. It is impossible to accurately determine price without knowing the costs. Because of the variation in costs between properties, you may see one property with a GRM of 6 and another with a Rent Multiplier of 15.
Since it isn’t very likely that one of those properties is a steal and other is a terrible buy, the difference is probably due to drastically different expenses. Remember, older properties have higher expenses so they will sell for lower prices. This may significantly affect the gross rent multiplier.
To learn better methods to analyze rental property, you really need to check out my article about analyzing rental property.
How to Calculate the Gross Rent Multiplier
- Create a list of recent sales in your market.
- Calculate the Gross Rent Multiplier for each property on your list.
- It is often a good idea to remove the “outliers.” That is the properties on the top and the bottom that are really far away from the average. Often these properties don’t reflect what’s normal.
- Determine the high, low, and average GRM.
Now that you have calculated the average gross rent multiplier in your area, you can use the second formula in order to evaluate potential deals.
Gross Rent Multiplier: Example 1
Let’s say you found that a GRM of 8 is average in your location. Use the new formula to calculate your potential investment:
Price = (GRM * Gross Rent)
So if the gross rent is $20,000/year, it looks like:
8 * $20,000 = $160,000
In this simplistic example, you may reasonably assume the value of a property earning 20,000 per year is worth around $160,000. You can get an idea if an investment is significantly over priced or under priced based upon this.
If the property has rent income of $20,000 but is listed for $250,000…perhaps it’s overpriced. On the other hand, if it was listed for $50,000, you may realize it needs some work!
GRM Example 2
You are looking at rental properties in an area that has a GRM of 8. You find two potential properties that both have gross incomes right around 40,000. Understanding how to use the Gross Rent Multiplier, you believe each should be worth around $320,000.
You notice one is priced at $250,000 and the other is priced at $340,000. Wow! What a steal! You should buy it up in a heartbeat, right? Being savvy, you look into it deeper.
The first property, listed at $250,000 was built in 1910, and has a high-efficiency heating system, for all of the units to share. The other property has 4 standard heating systems, one for each unit. Additionally, it was built in 1982.After some quick calculations, you find out the cheaper property actually, has about $10,000 extra per year in expenses!
Think Outside the Box
This example opens up some opportunities for you. You know that it is about $90,000 cheaper but has $10,000 extra per year in expenses. It may be possible to have the property appreciate if you can reduce the expenses! In this example, consider getting quotes to get the heat and other utilities sub-metered, that way you save money and earn some instant equity.
You found two properties, both priced the same, with the same multiplier, and with the same rents.
One is a completely remodeled multi-family built in 1890, and the other is a slightly outdated multifamily built in 1977. You learned earlier, that clearly the 1890 property is overpriced because it’s older and will require more maintenance, right?
Possibly, but in this example, we don’t know. The gross rent multiplier is the same, rents are the same, and the price is the same, but ages are different.
There is one major disparity, the older building was recently remodeled and the newer one was not.
Now, we know a few things because we are knowledgeable investors. First, we know that major renovations on properties before 1978 will require lead law compliance. This means the 1890 property is probably deleaded – a huge plus.
We don’t know the scope of work done yet, but if all piping, electrical, siding, and even insulation was done, the old 1890 building may not require any work for 30 years. On the other hand, the property built in 1977 is nearly 30 years old. Like an aging car, this property is starting to reach the point it will require extensive maintenance.
It may be possible that the old building is actually a great buy and the newer building is overpriced!
How It’s Related to other Rules of Thumb
There are a lot of rules of thumb floating out there, but a couple of the big ones you’ll hear about are the 1% and 2% rules. In a nutshell, the 1% rule states that you should “break-even” if your monthly rent is equal to 1% of the purchase price and the 2% rule is a good rule of thumb to be successful and profitable if the monthly rents are 2% of the purchase price.
So, if the purchase price is $100,000 then the rent should be $1,000 to break even and be near $2,000 to earn a healthy profit.
These rules are horribly inaccurate, but the gross rent multiplier and 1%/2% rules are essentially the exact same thing, except inverse of each other. The other difference is the GRM is usually calculated yearly while the % rules are done monthly.
Comparing the GRM and 1%/2% Rules
Using the example above, if a property sells for $100,000 and earns $1,000/month in rent, then the monthly rent is equal to 1% of the total purchase price.
The GRM would be:
So any property that meets the 1% rule will always have a GRM of 8.33 or lower. Similarly for the 2% Rule:
Any property that meets the 2% rule will have a gross rent multiplier of 4.16 or lower.
Pretty straight forward, right?
Consider the Pros and Cons Before Using the Gross Rent Multiplier
In conclusion, the GRM method is a good rule of thumb that can help you quickly analyze property and sort through stacks of potential investments. It’s also closely related to the 1% and 2% rules, as it’s just the inverse calculation and based yearly instead of monthly.
Take a word of caution though and understand that the gross rent multiplier does not take into consideration any expenses, so it’s impossible to make an informed final decision based solely on this method.