This week I’ve been preparing for a client meeting to discuss a strategy for buying the right investment property. Gross rent multiplier is a tool you can use to evaluate investment properties like the one my client purchase in the photo below.
In this article, when I refer to investment properties, I’m talking about 2-4 unit properties. When considering buying an investment property, there are many reasons why a 2-4 unit property makes for a better real estate investment than a single family home. Here are three:
- Less vacancy risk. If you have a rental house and someone leaves, you have a vacancy rate of 100%. When a tenant leaves a multifamily property, you have other units that can still be generating income.
- Easier to improve. When renovating a house, you have to do the interior and exterior before renting it. With a multifamily property, you can work on each unit as tenants come and go.
- Economies of scale. Your transaction costs, management costs and use of time will be less with a concentration of 2-4 units as compared to a single family home.
If you want to learn more about the advantages of investing in 2-4 unit properties, I’d recommend reading the book Investing in Duplexes, Triplexes, and Quads. Some sections are a bit dated as the book was written in 2006, pre-crash, but the core message and formulas still apply.
Gross Rent Multiplier
When determining the market value for a single family home, the typical method real estate agents use is finding comparable properties to compare to the subject property. This works well for single family homes and condos, but when it comes to 2-4 unit properties, this method doesn’t provide the full picture.
The gross rent multiplier (GRM) is the best way to determine the current market value of a 2-4 unit property because it measures the gross annual rents relative to the purchase price. This is an income approach to evaluating the value and is essential when vetting an investment property.
To calculate the GRM, take the purchase price and divide it by the gross scheduled annual rents:
GRM = Purchase Price / Gross Scheduled Income
If a property sold for $360,000 and the gross scheduled annual rents were $36,000 ($3,000 per month), then the GRM would be 10. So what does that mean? The table below is a general range for GRM values with explanations on what the property should be according to Larry Loftis, the author of Investing in Duplexes, Triplexes, and Quads. Larry Loftis is an attorney who is also a real estate investment expert.
20 and aboveHot property in a hot area in a seller’s market. Even if you put down 20%, you’ll have negative cash flow. Appreciation should be outstanding.
17 to 20Great property in a great area in a seller’s market. You’ll be lucky to get a positive cash flow with 15% to 20% down. Another appreciation play.
12 to 16You may have potential here. This should be good to a great area. You may be able to break even with 10% to 20% down. Excellent appreciation.
8 to 11This is a good range to shoot for if the area is okay, the property is in decent shape, and the tenants are not too bad. If you have all 3, don’t delay, it won’t last long. You should have decent cash flow with 10% to 15 % down. Decent cash flow, decent appreciation.
6 to 7This will not be a good neighborhood. Cash flow will be excellent, but appreciation will be bad. You probably will not tell your cousin that you own this property.
Under 6You will not want to be here at night. Cash flow will be great if you can collect it. Don’t count on much appreciation; there are not many buyers for these properties.
Gross Rent Multiplier Example
Let’s compare three actual properties listed on the San Diego MLS and see how gross rent multiplier can help determine the best investment.
Property #1: Triplex in North Park
GRM = 15.9
Property #2: Triplex in Normal Heights
GRM = 13.4
Property #3: Triplex in City Heights
GRM = 11.8
The best buy of the group is property #3 with the lowest GRM. These properties are close to each other, but the best location is property #2, since it is north of El Cajon Boulevard, which is a known division in metro San Diego neighborhoods of North Park and Normal Heights. If property #1 was north of El Cajon Boulevard, this property would have had the best location.
When comparing location and GRM, the best value, in my opinion, is property #2 in Normal Heights.
Keep in mind that this method of valuation helps both buyers and sellers. Savvy sellers will make improvements to raise rents, thus raising their property values based on GRM values. If you live in an area with high GRM values, a small increase in rent can have a significant effect on your property value.