Every investor has that certain item they look for in order to identify a good investment property; some use Gross Rent Multiplier (GRM), others use Price per Square Foot, others use Price per Door, while still others use Capitalization Rate (CAP). This certainly begs the question, who is right? Even more profoundly, is there a right or wrong when measuring the value of an investment? Let’s compare these different ways
The Gross Rent Multiplier (GRM) of a property is simple math; it is the number of times the value of a property can be divided by the gross potential rental income. For an example, if a property is listed for sale at $2.5 million and it brings in $250,000 in gross rental income, than the property has a GRM of 10. Okay, but what does that mean, is 10 a good number?
I use GRM as a filter when looking through investment property options. It would be rather cumbersome to extensively analyze every property that is listed for sale. Therefore you can use GRM to weed out the properties that do not generate enough cash to meet your objectives and it is an easy way to decide if the property is extremely overpriced. GRM however has one major shortcoming; it does not take any operating expenses into consideration. Let’s use another example but this time we have two buildings for sale and both have a GRM of 10. In this example both properties are expected to generate $250,000 of income. However property number one has 35% expenses which is $87,500 and property number two has 47% expenses which is $117,500. Since they both have a GRM of 10, are they still worth the same amount? If both properties are located in a 5.5% CAP rate area then property number one is worth $2,954,545 and property number two is worth $2,409,091. That is over a $500,000 difference in building value with only $30,000 variation in expenses. GRM can be a handy quick look tool but I wouldn’t put my money on it.
Price per square foot (PPSqFt) is another easy math problem; it is the building price divided by the total square footage of improvements. An example is a 12,000 square foot building listed for sale at $1.9 million. The price per square foot on this property is $158.33. This can tell you, when compared to other market data, if $158.33 is priced higher or lower than other buildings for sale. Price per square foot contains the same limitation as GRM in that it does not factor in expenses. Additionally, price per square foot doesn’t look at income either. In this case you could end up with a 12 unit property, renting out apartments at $25 per month and 500% expenses… Oh My!
Price per door is yet another way to evaluate the worthiness of an investment property. Everyone loves a low cost per door, more doors for less money. I too look for a low cost per door, but again it does not consider income or expenses. As an example, let’s take two properties that are currently on the market. (Please note this is a dramatization. Some names and locations have been changed to protect the innocent listing agents.) We will call property number one Peach Street and property number two will be Apple Avenue.
16 units total, all studio apartments
Total square footage is 4,080 and the price per square foot is $365
Total gross potential annual income is $111,600
Price per door is $93,125
16 units total, all 3 bedroom 2 bath apartments
Total square footage is 15,600 and the price per square foot is $143
Total gross potential annual income is $211,200
Price per door is $140,000
Which property is a better value? I suppose it depends what you are shopping for. Are you in the market for “potential” income? Do you want to buy square feet? If you really need to purchase a whole bunch of doors, I highly recommend Home Depot…they have much better pricing!
As investors we need to look at the bottom line, at the Net Operating Income (NOI) of the property. In order to make sure that the property can qualify for a loan or that we receive the ever so powerful positive cash flow, we need to take everything into account. We must look to the property’s Capitalization Rate (CAP rate).
The CAP rate of a property is the NOI divided by the purchase price. Because this calculation is based on NOI, it takes in account potential rent, minus vacancy and credit loss minus operating expenses.
The CAP rate method of evaluating investment properties is the most comprehensive of all the above mentioned techniques. Using GRM, price per square foot and per door can useful tools, but please use them with caution.
If you need any assistance determining the value of a commercial property, please give me a call today.
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