The gross rent multiplier and capitalization rate are some of the most commonly used metrics to gauge a property’s potential profitability. But did you know that these can give you a clearer picture into a property’s income potential? To explain gross rent multiplier vs cap rate, a gross rent multiplier compares similar properties based on how long it takes for the gross rental income to match your purchase price, while a cap rate finds what percentage return you can expect. Still, that’s just scratching the surface. So, let’s take a closer look at gross rent multiplier vs cap rate and find out how these can help with your investment decisions.
Key Takeaways
- The gross rent multiplier (GRM) is a screening tool that investors use to compare similar properties based on how many years it may take for the gross rental income to match the upfront purchase price.
- The capitalization rate (cap rate) measures the net operating income in relation to the property’s current market value to find what percentage return you can expect.
- GRM identifies potential opportunities quickly, while cap rate confirms whether a property’s income justifies its price and risk. In professional appraisals, this is known as the Income Approach to valuation.
What Is Gross Rent Multiplier (GRM)?
The Gross Rent Multiplier (GRM) is a financial metric real estate investors use to estimate the number of years it would take for a property’s gross rental income to cover its purchase price.
To go more in depth, whether you’re a new investor or a seasoned one, one of the first things that you look into to determine if it’s a good investment option or not is to look at its potential profitability. In our experience as a property management company, it’s one of the most popular performance indicators real estate investors use. But what is it, exactly?
The gross rent multiplier gives you a straightforward valuation that tells you the estimated years it would take for an income property investment to generate revenue to reach your ROI. It uses the gross rent for a year as the basis and is typically used to compare similar properties with the same characteristics (apartments vs apartments in the same area, SFRs vs SFRs, and so on). Brokers often favor GRM because gross income is easily verified through a rent roll. It is calculated using the formula:
Gross Rent Multiplier (GRM) = Property Price / Annual Gross Rental Income
What Is Cap Rate (Capitalization Rate)?
The capitalization rate (cap rate) measures the annual rate of return you can expect from a property by dividing its net operating income (NOI) by its current market value.
The capitalization rate (cap rate) is a fairly similar tool used by investors to gain insight into a property’s true income potential. The key difference between the two is that the cap rate takes into account the expenses involved in operating a rental income property. We’re talking about utilities, repair and maintenance costs, insurance, vacancy rates, and property taxes. By taking these into the equation, you’ll come up with the net operating income (NOI) and gain a more accurate assessment of your annual ROI.
However, the capitalization rate is not as straightforward in the sense that it is expressed as a percentage rate of returns. So, instead of a simple timeline of years to reach ROI, it offers an expected rate for the annual return that it can generate based on its net operating income and current market value/property price. Crucially, professionals also use the “Reverse Cap Rate” formula (Value = NOI/Cap Rate) to determine what a property should be worth based on the prevailing market rate.
Take note that there are two ways to calculate the capitalization rate – one uses the property’s current market value, and the other uses the property price upon purchase. However, the more commonly used is the market value, as it offers a more accurate and updated view of the property’s potential. On the contrary, using the property price can give unrealistic results if you’re looking at properties that were purchased long ago at significantly lower prices. Not to mention that property prices could not be applied to inherited real estate. That being said, the formula for the cap rate is:
Capitalization Rate = Net Operating Income / Market Value
How To Calculate GRM and Cap Rate (With Examples)
You can calculate GRM by dividing the property price or value by the annual gross rental income. Then, you can calculate your cap rate by dividing the net operating income by your current market value and then multiply that result by 100.
To gain a better understanding of the gross rent multiplier vs cap rate in gauging investment opportunities, let’s put these formulas into action. Let’s say that you’re looking at a $350,000 single-family rental property for a potential investment. The property owner tells you that the rental generates $30,000 of gross income annually. Following the formula, the GRM for this property is:
Gross Rent Multiplier = $350,000 (price) / $30,000 (gross) = 11.6
This means that the property will take approximately 11.6 or roughly 12 years to equal the cost of acquiring it. But what about the capitalization rate? First, you need to determine the operating expenses of the property. For this example, let’s say that the operating costs and vacancy allowances of the rental property amount to $13,200 a year. Therefore, the net operating income will be:
Net Operating Income (NOI) = $30,000 (gross) – $13,200 (operating expenses) = $16,800
Now that you have the NOI for the property, the capitalization rate is:
Capitalization Rate (%) = $16,800 (NOI) / $350,000 (Market Value) = 4.8%
When to Use Gross Rent Multiplier and Cap Rate
Use the Gross Rent Multiplier as a quick preliminary screening tool to compare similar properties, and the Capitalization Rate for a deeper, more accurate analysis of a property’s long-term profitability and risk after accounting for all operating expenses.
To go more in detail, let’s start with the gross rent multiplier. Generally, the GRM is used as a preliminary screening tool to determine which investment opportunities to look into among similar properties. Let’s say you’re looking at different SFRs and you find ones with GRMs at 8, 9, 12, and 15, you can easily see the expected ROI timeline for each one. You can take the properties with GRMs 12 and 15 off your list and pay closer attention to those with the lower gross rent multipliers. Note, however, that in high-demand areas like coastal California, a higher GRM may be acceptable if you have significant potential for capital appreciation.
Now, what the capitalization rate has to offer is a deeper insight into a rental property’s income potential. What’s even better is that you can use the cap rate to compare different properties, whether it’s an apartment vs house, old vs new constructions, city center vs suburb, etc.
Given that the cap rate provides a more accurate and up-to-date projection of a property’s income potential and efficiency, it’s best used to evaluate long-term hold investments and see if it can consistently generate income. It can also be a way for you to assess your risk tolerance and market position. The rule of thumb is that lower cap rates signal more stable, low-risk investments for a longer return timeline, while high cap rates indicate higher potential return but at a higher risk due to market conditions. Always verify your expenses meticulously, as inaccurately reported costs can artificially inflate a cap rate.
Also, neither GRM nor cap rates include your mortgage payments, so you should know that, too.
A Disclaimer
We’re only providing general information in this article for educational purposes only. While we aim for accuracy and reliability, the information shared is not meant to be relied on as legal, tax, financial, or specific regulatory advice. We strongly recommend that you always consult with a licensed attorney, CPA, or other qualified professional in your specific jurisdiction for advice tailored to your unique circumstances, as reading this blog does not establish a client or advisory relationship with BMG.
Partner with BMG on Your Real Estate Ventures
Stepping into real estate investing can feel daunting and overwhelming. Given the financial resources needed to acquire and operate an income property, it’s important that you utilize different performance indicators to help guide your investment decisions. Here, the gross rent multiplier (GRM) can be used to identify potential value based on the estimated years it will take for you to achieve your return on investment. On the other hand, the cap rate provides you with a clear picture of the property’s profitability and efficiency, especially for long-hold investments.
Need help in your investment journey? Partnering with the best property management company is just what you need. Here at Bay Property Management, we can provide you with all kinds of property management services to safeguard your investment even further. Our team of professionals can handle your rent collection, disputes, maintenance and repairs, lease drafting, lease enforcement, and more. What are you waiting for? Contact us today!