GRM, Cap Rate and IRR: when and how to use them
The gross rental multiplier (GRM), the capitalization rate (capitalization rate), and the internal rate of return (IRR) are three terms that you will often encounter in commercial real estate. By the time you finish this short article, you should have a good idea of 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 will hear when evaluating commercial real estate. If you know the selling or selling price of a property, as well as the maximum annual income that can be generated from current leases, you can calculate the GRM.
As an example, let’s take a multi-family property. Suppose the sale price is $ 1 million. There are 20 one-bedroom units, each of which rents for $ 500 a month and 20 two-bedroom units, each with an income of $ 650 a month. Assuming there are 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 Potential Gross Rental Income gives you the GRM, in this case 7.37.
By itself, that number is practically meaningless. It doesn’t tell you anything about vacancies, allowances, 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 I use it to remove a property from further consideration or to follow up with further inquiries. Most investors don’t even consider the GRM, but instead jump straight to the capitalization rate.
The capitalization rate uses net operating income, or NOI, as its starting place. Since the NOI reflects vacancies, losses and expenses, and also adds other income such as an on-site laundry, it is a much better reflection of the actual operation of the property.
The Cap Rate is mainly used when buying or selling a property. You can calculate the capitalization rate if you know the NOI and the selling or selling price. To find out what the upper limit 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 $ 800,000, doing the split yields an 8% capitalization rate. This is equivalent to putting $ 800,000 in a bank account at 8% interest and earning interest payments of $ 100,000 per year.
If you are buying class C apartments in your city and the average capitalization rate for recent sales is 8%, you will probably compare it to the capitalization rate being offered on a property for sale now. For example, if you can get a property for $ 1,200,000 that has a NOI of $ 145,000 per year, you can calculate that the Cap Rate is $ 145,000 divided by $ 1,200,000, or 8.28%. Since they offer a higher capitalization rate than the current average, it might be worth taking some extra time to explore. However, keep in mind that higher returns are often required on a higher risk deal.
The problem with relying too much on the capitalization rate is that it is just a reflection of a given moment in time. It shows the value of a property at the time of sale, but does not indicate a long-term profit. For that, you need the Internal Rate of Return or IRR.
The IRR is defined as the percentage rate earned for each dollar invested in each period in which it is invested. In other words, if a property is held for five years and then sold, the money received in the first year bears interest for four more years, while the income received in year five only bears interest that year. The sum of the total for each year leads to the IRR. Most people use a financial calculator or spreadsheet to calculate IRR.
The IRR is useful because it shows the return on investment over the entire period of ownership and includes the sale price in its calculation. An investor will use the IRR to estimate the potential return on a given amount invested. You can compare this number with the IRR of a competitive offering, as well as with other types of investment, such as stocks and bonds. In the latter cases, the IRR is generally referred to as yield.
Sometimes a property will have a higher capitalization rate, indicating a lower sales price, but a lower IRR, indicating a lower long-term return. Most investors trust IRR more than the other two measures when evaluating a new or recently completed opportunity.
The IRR is often calculated with and without taxes included. Obviously, the after-tax IRR will give you the bottom line for your money. However, if you also calculate the IRR before tax, the difference between the two rates may reveal your effective tax rate. For example, if your after-tax IRR is 16.65% and the pre-tax IRR is 20.19%, the difference between the two is 3.54. Dividing this number by the pre-tax IRR of 20.19 gives an effective tax rate of 17.55%. This is substantially lower than the investor’s income tax rate of 28 or 35%, which offers 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 a lot of valuable information about a deal.
The capitalization rate is useful when creating an offer. If a seller offers a property at a capitalization rate of 7 when the average for that property type at that location is 8%, an investor will often adjust their purchase offer to match the average capitalization rate. The current problem with Cap Rates is that there haven’t been enough recent sales to get a meaningful average for comparison.
The IRR is the best of the three numbers to give the investor a general idea of what kind of return to expect during the period of ownership. The after-tax IRR is the most accurate projection you can get of the final return on your investment dollars and can easily be compared to other investment alternatives.
