Gross Rent Multiplier (GRM), Capitalization Rate (Cap Rate) and Internal Rate of Return (IRR) are three terms you’ll often encounter in commercial real estate. By the time you finish this short article, you should have a good idea about what they are, why and when you would use them, and what their limitations are.
The GRM is the easiest to calculate, as well as the least informative number you’ll hear when evaluating commercial real estate. If you know the asking or selling price of a property as well as the annual maximum income that can be generated from the current leases, you can calculate the GRM.
As an example, let’s take a multifamily property. Assume the asking price is $1 million. There are 20 one-bedroom units, each renting for $500 per month and 20 two-bedroom units each bringing in $650 a month. Assuming no vacancies, losses or concessions, that totals $11,300 per month, or $135,600 of potential rental income per year. Dividing the purchase price by the Gross Potential Rental Income gives you the GRM, in this case 7.37.
By itself, that number has virtually no meaning. It tells you nothing about vacancies, concessions, expenses or taxes. About the only way you could use this number is to compare it to other GRMs for similar properties in the same general area. Only if one stood out from the pack would you use this to eliminate a property from further consideration, or to follow up with additional inquiries. Most investors don’t even consider the GRM, but jump straight to the Cap Rate.
The Cap Rate uses the Net Operating Income, or NOI, as its starting place. Since the NOI reflects vacancies, losses and expenses, and also adds in other income as from an on-site laundry, it’s a much better reflection of the actual operation of the property.
The Cap Rate is used mainly when buying or selling a property. You can calculate the Cap Rate if you know the NOI and the selling or asking price. To find out what the cap rate was on a recent comparable sale, divide the NOI by the purchase price. So, if the NOI is projected to be $100,000 next year, and the sale price is $1,000,000, doing the division yields a Cap Rate of 10%. This is equivalent to putting $1,000,000 into a bank account at 10% interest and getting interest payments of $100,000 per year.
If you are buying C class apartments in your city and the average Cap Rate for recent sales is 8%, you’ll probably compare that to the Cap Rate that is being offered on a property for sale now. For instance, if you can get a property for $1,200,000 that has an NOI of $100,000 per year, you can calculate that the Cap Rate is $120,000 divided by $1,200,000, or 10%. Since they’re offering a higher Cap Rate than the going average, this might be worth taking some additional time to explore. Keep in mind, however, that higher returns are often required in a deal with higher risk.
The problem with depending too heavily on the Cap Rate is that it’s just a reflection of a given moment in time. It shows a property’s value at the time of sale, but gives no indication of long-term gain. For that, you need the Internal Rate of Return, or IRR.
The IRR is defined as the percentage rate earned on each dollar invested for each period it is invested. In other words, if a property is held for five years and then sold, money received in the first year earns interest for four more years, while income received in year five only makes interest that year. The sum of each year’s total leads to the IRR. Most people use a financial calculator or spreadsheet to calculate the IRR.
The IRR is useful because it shows the return on investment over the entire ownership period and includes the sale price in its calculation. An investor will use the IRR to estimate the potential return on a given amount put into the investment. She can compare this number to the IRR of a competing offer as well as other investment types such as stocks and bonds. In the latter cases, the IRR is generally referred to as the yield.
Sometimes a property will have a higher Cap Rate, indicating a lower sales price, but a lower IRR, indicating a poorer yield over the long haul. Most investors rely more on the IRR than the other two measures when evaluating a new opportunity, or a just-completed one.
The IRR is often calculated with and without taxes figured in. Obviously, the after-tax IRR will give you the bottom-line return on your money. However, if you also figure the IRR before taxes, the difference between the two rates can reveal your effective tax rate. For instance, if your after-tax IRR is 16.65% and the before-tax IRR is 20.19%, the difference between the two is 3.54. Dividing this number by the before-tax IRR of 20.19 yields an effective tax rate of 17.55%. This is substantially lower than the investor’s income tax rate of 28 or 35%, offering another benefit of owning commercial real estate.
As you can see, the GRM is the least powerful and least used of these measures because it leaves out so much valuable information about a deal.
The Cap Rate is useful when creating an offer. If a seller is offering a property at a 7 Cap Rate when the average for that property type in that location is 8%, an investor will often adjust his purchase offer to match the average Cap Rate. The current problem with Cap Rates is that there haven’t been enough recent sales to get a meaningful average to compare to.
The IRR is the best of the three numbers to give an investor an over-all idea of what kind of return to expect over the ownership period. The after-tax IRR is the most accurate projection you can get of your bottom-line yield on your investment dollars and it can easily be compared to other investment alternatives.
- Advantages of Using IRR (brighthub.com)
- How to Calculate a Project’s Internal Rate of Return (brighthub.com)
- Comparing NPV & IRR (brighthub.com)