Anyone who has been investing in real estate income property long enough (let’s say for the past two days) has heard about capitalization rate (cap rate) and gross rent multiplier (GRM).

It would be difficult, in fact, not to look at an Annual Property Operating Data (APOD) or Proforma Cash Flow Statement that didn’t include a computation for cap rate or GRM.

Why, because both cap rate and GRM are popular ways to measure the performance of an investment property during the real estate investing process.

Though neither cap rate nor GRM is a magic bullet, and by themselves should not be relied on by real estate investors to make a real estate investing decision, each does provide the real estate investor something of value.

Gross Rent Multiplier

Gross rent multiplier is computed to show the ratio between the price of the rental property and the rental property’s gross scheduled income. GRM tells the investor what the property price is based upon each $1 of annual gross possible income.

For example, if a duplex is priced at $300,000 and has annual gross scheduled income of $30,000, the investor would know that the duplex has a 10.0 GRM—the price of the duplex is 10 times the annual gross income.

HINT: Consider GRM as the number of years it takes the gross income to equal the sale price and you will get the idea.

The advantage of using GRM is that it is a quick way for a real estate investor to take a reading on a property’s price—either when comparing it to the GRM of sold properties, or the GRM of other properties currently for sale—without the need of a calculator.

The primary disadvantage of GRM is that it uses the gross income and does not consider either vacancy rate or operating expenses.

Capitalization Rate

In practice, cap rate expresses the percentage rate between a property’s net operating income to its value, or sale price.

For example, if the same duplex priced above at $300,000 has a net operating income (NOI) of $21,000, the capitalization rate would be 7.0%–the NOI is 7 percent of the sale price.

The advantage of cap rate is that it measures NOI–gross income less vacancy less operating expenses—that essentially becomes the amount of money available to make the loan payment, and as such, provides a good first-glance assessment of a property’s ability to pay its own way.

Summary

There is no one ideal GRM or cap rate, nor does either alone provide a true picture of a property’s profitability and should not be used to make a real estate investing decision without consideration for other factors about the investment property.

Moreover, the old adage, “garbage in-garbage out” is accurate about both GRM and cap rate. The measurements can be helpful to a real estate investor conducting a preliminary survey. But only when the numbers used to make the computations are realistic.

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