Remember, lower is better. So based on these gross rent multiplier calculations, the first property appears to be the best investment opportunity. However, keep in mind this is just one piece of the puzzle. For example, if the single-family home is rent-ready and the others need extensive work, it could be the best investment even though it has the highest GRM.
Advantages and drawbacks
Like all other ways of evaluating potential investment properties, the gross rent multiplier has its pros and cons.
The advantage of using the gross rent multiplier is that it's easy. Simply divide a property's price by its expected monthly rent to calculate it. By doing this, the gross rent multiplier can help you narrow down hundreds or even thousands of real estate listings into a short list of properties to consider.
However, the simplicity of the gross rent multiplier is also its biggest drawback. Just because a property has a gross rent multiplier below 100 (or any other threshold) doesn't necessarily mean it's going to be a good investment. As an example: I often come across properties that have very attractive gross rent multipliers but need tons of maintenance, are in undesirable locations, or have other major issues. I call these types of properties "value traps," and it's a very important concept that a low gross rent multiplier doesn't automatically mean a good investment opportunity -- it's merely a way to narrow down a search before doing additional due diligence.
Also, there are two potential flaws with the GRM calculation. First, you're generally using the asking price of the property, which isn't necessarily the actual purchase price you could buy it for or its actual property value. Second, unless there's already a tenant in place, you'll base the calculation on estimated rent, which may or may not be accurate.
Other important metrics to use in real estate investing
As mentioned in the last section, no real estate investing metric is perfect all by itself. And the gross rent multiplier is not an exception. The best way for a real estate investor to use it is as part of a "toolkit" of metrics that can help you evaluate if a real estate investment is worth pursuing.
Cap rate – The cap rate (short for capitalization rate) can be more useful when analyzing an investment property's profitability, simply because it considers the property's net income after expenses, like property tax, insurance, etc., as opposed to just its gross income.
To calculate the cap rate, you divide the property's annualized net operating income (NOI) by its cost and convert the result to a percentage. For example, a property that generates NOI of $70,000 per year and costs $1,000,000 would have a cap rate of 7%. And it's worth pointing out that unlike the gross rent multiplier, higher cap rates are better. Cap rate is most often used when evaluating commercial real estate but can certainly be used for residential properties as well.
Cash flow – One important part of any real estate investment analysis is cash flow. Many investors have specific cash flow targets they want to meet, while others (myself included) simply insist that every rental property they own has positive cash flow. Calculating cash flow for a rental property can be a bit complicated and requires some assumptions, so here's a quick guide to cash flow analysis that can help you get started.
Cash-on-cash return – Finally, since most investors finance their investment properties, cash-on-cash return can be useful, especially for comparing properties that require different down payments or upfront repair costs.
Here's how it works. Let's say that I buy a single-family rental property for $100,000 and put a $25,000 down payment on a mortgage. I also spend $5,000 shortly after closing to replace the property's HVAC system, making my total out-of-pocket acquisition cost $30,000. After expenses, the property produces cash flow of $200 per month, or $2,400 per year. Dividing the cash flow by my acquisition cost shows a cash-on-cash return of 8%.
How to use the gross rent multiplier
The gross rent multiplier isn't a great all-in-one metric that can tell you whether a particular property is a good investment opportunity or not. Instead, it's a good screening tool that can help you narrow down all of the real estate listings in your market to those that are worth a closer look.
Some investors have a specific cutoff, such as a maximum GRM of 100. Some are even more aggressive and want a GRM that's even lower before they'll get interested. You'll develop your own rules of thumb over time as you get a better feel for your particular rental market, but the bottom line is that the gross rent multiplier can help narrow down your search and point you in the direction of the best investment opportunities.