Let’s add another tool to your growing toolbox of real estate evaluators: the Gross Rent Multiplier (GRM).
Evaluating medical school candidates is a lot like looking for real estate deals. There are a ton of potential students. Some are well-qualified, many are average, few are outstanding, and a few are stinkers. Nearly all will apply to a huge amount of schools in the hopes of finding one. They will puff their resumes, hoping to downplay any deficiencies, and perhaps just one school will overlook any problems and take them on.
For the school, each student brings some prospective income in the form of tuition. That tuition is set well in advance and the school can predict its income for the next few years. Students also bring cost. The fixed costs are in payments to the instructors, huge amounts of medical equipment, cleaning, insurance, facility costs, and others. Variable costs include remediating problem students. Choosing a poor student can have a cost in morale and time as well.
The selection committee for a school receives hundreds or thousands of applicants every year and they simply don’t have time to fully evaluate each of them. They need to set some bars to ‘weed out’ the applicants, tossing them into the trash before they ever read about what great things the student invented for irrigation in Zimbabwe or the lives saved heroically in that tragic bus accident. For some schools, if your MCAT examination score is not above 500, your application is trashed, thus removing half of the applicants immediately. Next, they select out for undergraduate grade point average. They will quickly narrow down the applicants to a few that meet all their criteria. This certainly won’t mean everyone left gets an offer, but it takes much less time to fully evaluate each applicant once they have been narrowed down. It’s a tragedy for that genius student who has test-taking anxiety, but the process is deemed necessary given the time constraints.
It’s very similar for your selection process. When you are starting a campaign looking for rental properties, you will have a lot of prospects. There are a lot of things for sale out there and they are all unique snowflakes and you have got to narrow down the list before you commit to spending large amounts of time evaluating them. Doing a careful evaluation includes taking a few hours to gather the numbers, to spreadsheet out the numbers, to visit the property and look for necessary repairs, to interview the tenants and possibly the owners, to pull records, and to get an inspection and appraisal. Each step takes more time and money and you can’t do this for every one. You will probably weed out some gems but you’ll find a bunch more in the end.
Wouldn’t it be great if you could narrow down the selection process with just the knowledge of the sale price and the rents, which are pretty easy to verify?
Enter the Gross Rent Multiplier
The GRM is a quick way of evaluating a property’s sale price as a multiple of the gross annual rent. Recall that gross rent is the scheduled rent received over the year. If you evaluate a ten-unit property and each unit takes in $1,000 per month in rent, you will have a gross annual rent of $120,000.
Gross annual rent = 10 units * $1,000 / unit * 12 months = $120,000
The owner of this property offers to sell it to you for $900,000. To find the GRM we divide the sale price by the gross annual rent:
GRM = $900,000 / $120,000 = 7.5
Some tell you that this figure can be thought of as the number of years it takes to completely recoup your sale price. I think that is fairly confusing as you won’t be able to keep all 120k each year due to expenses. However, looking at it this way is a nice way to remember that lower GRM numbers are better. If the sale price for this building was $120,000 and had the same rent, then the GRM would be 1, an amazing number! Lower GRM = better.
Advantages of Using the GRM
- Speedy – Every listing will give you enough information to calculate the annual rent and will give you the asking price. That’s all you need to calculate the GRM
- Weeds out deals – it helps you to remove deals that probably won’t work
Disadvantages of Using the GRM
- Simplistic – Doesn’t take into account any expenses. Properties that have different expenses (for instance snow removal on a large parking lot) won’t be appropriate for comparison
- Estimates Collected Rents – Uses only the gross scheduled income, doesn’t take into account for vacancy
I look for a GRM between 4 and 10. Too high and the deal is likely to run in the red. Too low and there are probably some shenanigans going on with the numbers. To be sure, I will look at those low GRMs a little further.
You might lose a random good deal using the GRM to week out. Just as I feel bad for the medical students that didn’t make ‘the cut’ but could have been fantastic, I also feel bad for the properties that are cut due to GRMs outside my acceptable range. When starting out with few deals, consider using the GRM along side the other tools I taught you to generate a picture. No single tool will tell you if the deal is good or not. When you get bigger, you can afford to let some good deals go.
Begin calculating the GRM in every multifamily deal you come across. Keep these in a spreadsheet and soon you will have a great picture of the GRMs in your market.