GRM, Cap Rate and IRR: when and how to use them
Gross rent multiplier (GRM), cap rate (cap rate), and internal rate of return (IRR) are three terms you’ll often find 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’ll hear when evaluating commercial real estate. If you know the sale or sales 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. Assume the sale price is $1 million. There are 20 one-bedroom units, each renting for $500 per month, and 20 two-bedroom units, each earning $650 per month. Assuming no vacancies, losses or concessions, that adds up to $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 tells you nothing about vacancies, concessions, expenses, or taxes. The only way you can use this number is to compare it to other GRMs for similar properties in the same general area. Only if one stands out from the package would I use it to remove a property from further consideration or to follow up with additional queries. Most investors don’t even consider the GRM, but jump right into the cap rate instead.
The capitalization rate uses net operating income, or NOI, as its starting point. Since the NOI reflects vacancies, losses, and expenses, and also adds other income like an on-site laundry facility, it is a much better reflection of the actual operation of the property.
The capitalization rate is used primarily when buying or selling a property. You can calculate the capitalization rate if you know the NOI and the asking or selling price. To find out what the capitalization 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 sales price is $800,000, doing the split gives you a capitalization rate of 8%. This is equivalent to depositing $800,000 in a bank account at 8% interest and earning interest payments of $100,000 per year.
If you’re buying C-class apartments in your city and the median cap rate for recent sales is 8%, you’ll probably compare that to the cap rate being offered on a property for sale now. For example, if you can get a property for $1,200,000 that has an NOI of $145,000 per year, you can calculate that the capitalization rate is $145,000 divided by $1,200,000, or 8.28%. Since they offer a higher cap rate than the current average, it might be worth taking some extra time to explore. Keep in mind, however, that higher returns are often required in a higher risk business.
The problem with relying too heavily on the cap rate is that it is only a reflection of a given moment in time. It shows the value of a property at the time of sale, but does not give any indication of long-term profit. 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 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 earns interest for four more years, while the income received in year five only earns 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 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 invested. You can compare this number to the IRR of a competing offer, as well as other types of investment, such as stocks and bonds. In these latter cases, the IRR is generally called the yield.
Sometimes a property will have a higher cap 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 opportunity or one that has just completed.
The IRR is often calculated with and without tax calculated. Obviously, the after-tax IRR will give you the ultimate return on your money. However, if you also calculate the IRR before taxes, the difference between the two rates can reveal your effective tax rate. For example, if your after-tax IRR is 16.65% and your pre-tax IRR is 20.19%, the difference between the two is 3.54. Dividing this number by the IRR before taxes of 20.19 gives an effective tax rate of 17.55%. This is substantially lower than the investor 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 cap 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 in that location is 8%, the 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 to compare against.
The IRR is the best of the three numbers to give the investor a general 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 the ultimate return on your investment dollars and can be easily compared to other investment alternatives.