Actually, we’re going to talk about both GRM and Cap Rate, as they each have their value in the due diligence process involved in buying or selling real estate investment property. They can support each other, and both are valuable tools for the real estate investor’s toolbox.
GRM as a fast comparison tool – First, let’s see how we calculate GRM:
Market Value divided by Annual Gross Income = GRM
So, if we are considering the purchase of a property at $750,000, and an annual income from rents of $110,000, we have:
$750,000 / $110,000 = 6.82 GRM
You can also work it the other direction if you’re considering selling a property. Taking an area average GRM and multiplying it by your annual gross income, you can get an estimate of a place to start for setting a selling price.
The problem with GRM is that it isn’t a really precise tool. However, it is fast, particularly when you can get some data from the area as to other properties that have sold, and their GRMs. It is a fast tool, allowing an investor to quickly compare a number of properties for the purpose of honing in on those that appear to present the best opportunity. Then, more detailed analysis is begun, frequently using Capitalization Rate as one of the tools.
Cap Rate for rental property valuation – If you’re purchasing property, using the cap rate of similar recently-sold properties can give you a better approximation of value than GRM. Once you’ve narrowed the field with GRM, you can look at cap rate. It is calculated using the sold price of a property and the net rental income after expenses. Using an example six unit property that sold for $300,000 and had a net operating income of $24,000 divide the net income by the selling price:
$24,000 / $300,000 = .08 or 8% Cap Rate
What is a good cap rate? This varies with current markets and by area. However, there will be a number that you can get from a real estate professional, business broker or public records in the area. If area properties are showing a cap rate of 10%, then our example property might not be a good investment unless there is opportunity to raise rents or cut expenses.
Using GRM and Cap Rate, the real estate investor can hone in on promising properties. Then a more thorough analysis might turn up ways in which the cap rate can be improved, or you may just find a bargain with an excellent cap rate above the area market.