Many investors have a favorite strategy for weeding through the numerous income properties on the market in their search of a solid investment. Some use the “price-per-door” as a benchmark. Others consider the “gross rent multiplier (GRM)”. Yet others are convinced that capitalization (cap) rates are the way to go.
Which evaluation tool is best?
Investors have asked me the above question numerous times. A more profound question would be, “Is there really a BEST way? Let alone a right or wrong way?” Let’s explore some of the common comparison strategies.
This technique is extremely easy to apply. Simply take the building price and divide by the number of total square footage of improvements. Thus, a 12,000 square-foot property with a list price of $1 million has a price-per-square foot of $83.33/sq. ft. This can be a useful tool when comparing different properties in a demographic area. It is not, however, without its limitations. For example, this method does not take income or expenses into account. Evaluating a property exclusively with this method and you could find yourself money pit and you wouldn’t even know it.
Gross Rent Multiplier (GRM)
The gross rent multiplier is another simple comparison tool, one that is slightly more useful than the price-per-square foot method. To calculate the GRM of a property, simply divide its sale price by its gross rental income. For example, a property listed at $2 million that brings in a gross rental income of $200,000, then it would have a GRM of 10.
The property’s GRM is useless unless you have a good idea of typical GRMs of similar properties. Armed with this information, the GRM is a great way to filter obviously overpriced properties. Be careful, however, because the GRM method, like the price-per-square foot technique, fails to figure in expenses.
This is a popular method. Simply divide the property’s list price by its number of dwelling units. While I look for low price-per-doors during my property search, I use caution because, like the price-per-square foot method, it fails to account for income or expenses. The following illustrates my point.
One Main Street
Gross Potential Annual Income $110,000
Five State Street
Gross Potential Annual Income: $210,000
While One Main Street has a much lower price-per-door than Five Main Street, it also generates $100,000 in annual income.
Capitalization (cap) rate
This method is the most comprehensive method of them all. Take a property’s Net Operating Income and divide by its sales price to come up with its cap rate. Since the net operating income already accounts for expenses and income, it is undoubtedly the most complete evaluation method. Of course, without scouring the rent rolls and income statements, it is difficult to tell whether a listing’s numbers are accurate.
The best thing to do during your search is employ a variety of the above. Know that none in inclusive and always proceed with caution. There is no shortcut for due diligence. Until next time, happy investing!