Have you ever thought of finding out a quick fix solution to value commercial properties, before buying it? Have ever questioned yourself which is the best barometer in vogue?
The most common way to determine the fair valuation of a commercial property is through Gross Rent Multiplier which is the ratio of the price of a real estate to its scheduled monthly rental income; before deducting operating expenses such as utilities, property taxes, insurance, etc.
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In other words, the GRM is the number of years, a property would take to pay for its cost – a lower GRM is always desirable for a prospective real estate investor. Gross Scheduled (monthly) Income is the potential revenue from a property if it is 100% occupied.
While on first instance it might look a little tricky affair, but on the contrary, it is quite easy to calculate GRM, as long as you are privy to some basic information. In fact it is expedient and a less complex valuation methodology and due to its simplicity, multiple properties can be scanned efficiently.
This ratio can be used to compare similar real estate investments in a given place. It is the approximate value of an income producing commercial property and hence is and it a very precise tool to get the true value of a property. Though GRM is a simple and popular
method of gauging the investment verticals in the commercial real estate industry, it also has several built-in limitations, which we will discuss one by one, as we go deeper into the topic.
Example: Say, when a property is rented at Rs.1,200 per month, it produces annual revenue of Rs.14,400 in terms of rent. Now if the price of the property is 1,44,000, then:
Gross Rent Multiplier (GRM) = Property Price / Gross Rental Income = 10.
So what does this GRM of 10 mean?
It means that an investor must be willing to pay a multiple of 10 on the gross annual rent to buy this asset. Which when extended means that when you are comparing this factor with similar properties in an area it can throw before you potential acquisition opportunities; if one of the properties has a smaller GRM than the others. In calculating GRM, it is the annual figures which are used and not the monthly ones.
If the Gross Rent Multiplier or GRM of the property is too high or too low, as compared to the recently sold comparable properties then probably it indicates that either there exists some problem with the real estate asset or it is a case of gross-over pricing.
Let’s break this subject a bit further:
Say we’re comparing two commercial real estates — one that fetches Rs.5,000 in rent, and another that collects Rs.5,500 in rent. We will have to contextualize those numbers against property cost. If both the properties cost almost the same price, then the one which gives a rent of Rs.2,000 is the better deal. Right?
But wait!! What if the two properties are perched at different prices? Then?
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Case I:
The price of Property A = Rs.20,00,000 and it generates a rent of Rs.5,000 per month
Case II:
The price of Property B = Rs.11,00,000 and it generates a rent of Rs.3,500 per month
How to find out in a simple way, which is a better bargain? Here is what GRM will help us.
Hence, using the formula of, Gross Rent Multiplier or GRM = Property Price / Potential Gross
Rental Income, we get:
GRM1 = Rs. Rs.20,00,000/Rs.5,000 = 400 month
GRM2 = Rs. 11,02,500/Rs.3,500 = 315 months
Therefore, using the Gross Rent Multiplier method we find that Property B is a better
option since it pays its price earlier than the Property A.
The GRM gives a fair comparison among the properties at a place. It is similar to the price-
to-earnings ratio or P/E ratio in stock or share market — it is one of the major parameters of
valuation of commercial real estates, but not the final word in the realms of real estate
investments.
Now, as a corollary, we can also find the price of a commercial real estate, if we arrange the
GRM equation in the following manner:
Price = Potential Gross Income x Gross Rent Multiplier.
Advantages:
➢ The biggest advantage of the GRM metric is that it requires very little information to
process the valuation of commercial real estates, giving it a level of an easy tool.
GRM can be used to quickly survey any market by filtering out properties with a low
price relative to gross potential income.
➢ GRM overcomes the inherent flaws associated with Price-per-unit concept for
comparing similar properties; since the former considers the rent roll or income
stream while the latter doesn’t.
➢ Because the GRM is a ratio of price and rent, if one of the variables changes, the
outcome will also change; thus giving a seller or buyer an indication whether the
price of a property is a bit higher or lower side than the overall market condition.
➢ Rent of a commercial real estate is market driven or it depends how much a tenant is
willing/able to pay. By factoring in a market-driven data point (income), GRM is a
reasonably reliable instrument, especially in areas where operating costs are more
or less uniform across the domain.
➢ Although it is implied that this is not a good valuation model, it does suggest a "back
of the envelope" swift route.
Disadvantages:
➢ Since it takes into account gross instead of net income, GRM fails to differentiate
among properties with lower or higher operating expenses and vacancies.
➢ It is a rough valuation technique and hence changes in interest rates or inflation can
distort the outcome in the short term.
➢ This method assumes uniformity in properties across similar bracket, however,
expense ratios among such properties often vary widely, due to factors like deferred
maintenance, property age and the quality of property managers.
➢ In this system the estimates are based on gross rental income, while a property is
purchased based primarily on its net earning power (NEP); bringing about
aberrations. It is highly possible that two properties can have the same NEP even
thought their gross incomes or expenses may differ significantly; leaving a possible
conduit for misuse by the charlatans and swindlers.
➢ This modus operandi doesn’t take into account, the economic life of comparable
properties. Thus, there are likelihoods that a new property or a 50-year-old one
might be assigned the same rate by an inexperienced real estate investor;
considering that they generate equal incomes.
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Conclusion: There are generally three primary methods of valuing a commercial real estate:
o Sales comparison approach,
o Cost approach, and
o Income capitalization approach.
Gross Rent Multiplier though comes under the approximate income approach, it is normally
not used by professional to find out accurate estimates buy or sale price in a given
marketplace. However, as mentioned above, I reiterate that it's simple and saves time as it
uses information that is easy to obtain.
It should be used basically to filter potential investment scopes from a large pile of
properties hanging from the same tree, saving you from the drudgery of hours or even days
worth of complex calculations.
Moreover, since many properties don’t consider every expense in their public listing, it
might take considerable time and effort to jot down the data towards finding out a detailed
expense report. Herein GRM comes handy, without piecing all the information from the
jigsaw puzzle.
With the abundance of information available online, it should be fairly easy to calculate the
GRM of commercial properties from cues, culled out from online commercial real estate
websites, research providers or real estate agents/brokers.
Therefore, you should always keep in mind the above limitations and use it along with other
financial metrics like a full discounted cash flow analysis, to get a reasonably accurate value
of an apartment in an area.
In the end, it can be concluded that while the GRM approach of determining the value of
commercial property has its shortcomings, it actually gives a ballpark value which is actually
quite accurate and makes sense once you are well aware of the basics of commercial
appraisals.
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