Investor can vary from first time investors buying their first rental property to very sophisticated and experienced real estate investors.
Investors will often utilize or discuss certain mathematical formulas to help assess the investment potential of a property.
This Q&A will review some of the more common formulas investors utilize and discuss what is being calculated and what the utility of the formula is for investors.
Q 1. What is the gross rent multiplier?
A The gross rent multiplier (“GRM”) is a commonly used method of evaluating a commercial real estate investment by calculating the number of years it would take for the annual gross rent received for the property to total the price paid for the property.
The resulting number can be used as a tool for investors to quickly survey the properties in a particular market in order to identify which properties are priced lowest in correlation to the market based gross potential income. The lower the gross rent multiplier the higher the rate of return on an investor’s initial investment.
Q 2. How is the gross rent multiplier Calculated?
A The GRM is calculated by dividing the price of the subject commercial property by the projected annual gross income.
The GRM does not include expenses such as property tax, insurance, operating costs, vacancies etc.
To illustrate the GRM, let’s consider a commercial property priced at $2,000,000 where the gross rental income for the whole of 2014 is projected to be $200,000. In this case, the GRM, taken by dividing $2,000,000 by $200,000, would be10x. This means that, at this gross income, it would take 10 years for the investor to recoup the purchase price of his investment. Remember, the lower the GRM, the more gross rental income the investor will receive for each dollar invested.
Q 3. What is a good gross rent multiplier?
A There is no general answer to this question because average GRMs will normally vary with respect to both marketplace and the type of commercial property. For example, the average GRM of apartment buildings in Beverly Hills last year might have been 20x while that of industrial properties in Chatsworth were 8x. For this reason, the GRM is best used as a comparative tool for evaluating multiple properties of the same kind in the same geographical or trade area.
Q 4. When should I use the gross rent multiplier?
A The GRM requires very little information to calculate and it provides a quick and easy tool to evaluate comparable properties within the same market area. Comparable properties should have approximately the same gross rent multipliers. If the property does not, the property may require additional investigation to evaluate the reason for the discrepancy.
As the GRM does not take into account taxes, operating costs, insurance or vacancy rates it does not give the investor a complete and accurate projection of the potential return on a particular investment. , However, it is a concept that can be easily understood by investors. Consequently, it may be a good place for investors and licensees to start in locating a sound investment..
Q 5. What is a “capitalization rate”?
A The capitalization rate (or “cap rate”) calculation is another popular formula used in valuing commercial real estate. It is a measure of return on a commercial property based on its projected net operating income (“NOI”) for the first year of ownership. This method of evaluating commercial property is more complete and accurate than the GRM because it takes into consideration taxes, potential vacancy, insurance and other operating costs for the investor. However, this calculation is intended to show an investor’s annual return on an all cash investment and does not take into consideration any interest on a loan if the seller obtains financing for the property.
Q 6. How is a cap rate calculated?
A Cap rates are calculated as follows:
For the purposes of this calculation, “annual net operating income” is the total annual gross rental income less property taxes, vacancy rate, insurance and other operating expenses. These variables will generally vary between properties.
Q 7. When should I use a cap rate?
A Similar to the GRM, the cap rate is best used as a tool to compare like-in-kind properties in the same marketplace at the same period in time. Therefore, this calculation should be used by investors and licensees to ascertain 1) approximately the amount of annual income they should expect to receive from a particular investment and 2) how one potential commercial real property investment may compare to other similar, available properties in the same marketplace.
Also, in the event that a licensee has a client looking to sell a commercial property, the cap rate can be used as an effective tool to help establish a listing price. For example, if your client would like to sell an apartment building with an NOI of $100,000, you may want to show him the value of his or her property at a 5% cap, a 6% cap and a 7% (assuming this was the average range of cap rates for other apartment buildings sold recently in the same marketplace) in order to help the seller determine a listing price. You would then calculate this price as follows:
Again, for the purposes of these calculations, there is no general “right” cap rate. Instead, REALTORS® should look at the cap rates of recently sold or listed comparable properties as well as the goals of the particular client when deciding on an appropriate listing price.
Q 8. What are the down sides of using cap rates?
A As mentioned above, one of the more prominent weak points of using cap rates to determine the value of commercial real estate is that they do not take into consideration the economic impact that financing will have on the investment.
Additionally, commercial real estate investors often seek properties with the potential for future up-side. This is often referred to as “value-add.” One of the most common ways for investors to do this is to buy into a commercial property with below market rents (preferably expiring in the near future) and later raising those rents for a boost in NOI. Due to the fact that cap rates generally consider only the NOI produced in the first year of ownership, a licensee may miss a potential value-add opportunity if he solely considers the cap rate without further due diligence.
Q 9. Can I value commercial real property by using price per square foot comparables?
A In residential real estate, brokers often use price per square foot comparables in determining a reasonable price for a property. In commercial real estate, price per square is often used in addition to cap rates and other calculations of value when comparing like-kind properties in the same market place.
The “price per square foot” of a property is taken by dividing the total price of the property by the amount of gross square feet that make up the structure on the property. For example, if 5,000 square foot office building is offered at $2,000,000, its respective price per square foot is $400 (2,000,000/5,000 = 400).
However, this calculation does not take into consideration the amount of units or quality of the complex in each property and thus can be an inaccurate representation of investor value when evaluating apartment buildings or other multi-family investment properties. Generally, monthly rental prices for apartment units are not calculated as a measure of price per square foot, but instead by taking into account the amount of bedrooms, building amenities, quality, etc. Consequently it is not uncommon for one apartment unit to rent for the same amount (or even more) than another unit in a different complex in the same area; even if it is smaller. As a result, two apartment buildings that have the same total livable square footage and are located in the same marketplace (or even on the same street) may produce different NOI’s and will thus have different values for potential investors.
Q 10. Can I value apartment buildings and other multi-family properties by using price per unit comparables?
A This method of commercial property valuation is generally used exclusively for multi-family properties. An apartment building’s “price per unit” is taken by dividing the total price of the property by the amount of units in that building. For example, a 12-unit apartment building being listed at $1,200,000 has a “price per unit” of $100,000 (1,200,000/12 = 100,000).
Similar to using price per square foot comparables, price per unit comps can be a useful tool when combined with more precise calculations or to quickly filter investment opportunities in a given marketplace. However, due to the fact that this measurement does not consider operating costs or net income, it should be used by neither licensees nor investors as a sole means of determining the soundness of a potential investment opportunity.
Q 11. Where can I obtain additional information about this and related subjects?
A This legal article is just one of the many legal publications and services offered by C.A.R. to its members. For a complete listing of C.A.R.’s legal products and services, please visit car.org/legal.
Readers who require specific advice should consult an attorney. C.A.R. members requiring legal assistance may contact C.A.R.’s Member Legal Hotline at (213) 739-8282, Monday through Friday, 9 a.m. to 6 p.m. and Saturday, 10 a.m. to 2 p.m. C.A.R. members who are broker-owners, office managers, or Designated REALTORS® may contact the Member Legal Hotline at (213) 739-8350 to receive expedited service. Members may also submit online requests to speak with an attorney on the Member Legal Hotline by going to http://www.car.org/legal/legal-hotline-access/. Written correspondence should be addressed to:
CALIFORNIA ASSOCIATION OF REALTORS®
Member Legal Services
525 South Virgil Avenue
Los Angeles, CA 90020
The information contained herein is believed accurate as of January 28, 2015. It is intended to provide general answers to general questions and is not intended as a substitute for individual legal advice. Advice in specific situations may differ depending upon a wide variety of factors. Therefore, readers with specific legal questions should seek the advice of an attorney. Written by Michael Hillel, extern, Loyola Law School, reviewed and revised by Sanjay Wagle, Esq.
Copyright© 2015, CALIFORNIA ASSOCIATION OF REALTORS® (C.A.R.) Permission is granted to C.A.R. members to reprint this material in hardcopy or PDF format only for personal use or with individual clients. This material may not be used or reproduced for commercial purposes. Other reproduction or use is strictly prohibited without the express written permission of the C.A.R Legal Department. All rights reserved.