In an earlier article “How much should I pay for an investment property,” we discussed the methodology behind estimating value of Single Family Residences. As we discussed, the CMA (Comparative Market Analysis) looks at similar houses which sold, and then makes adjustments to the sold prices in order to accommodate the differences in condition, amenities, size, etc. between those sold comps and the subject property.
The rationale in the apartment space is somewhat different. Actually, it’s similar when we consider small apartments (4 and under) and how to determine how much to pay for a fourplex. But things get somewhat different when we consider bigger stuff. So, let us discuss…
Value is Based on Income
Put in the most basic terms, the reason we buy apartments, and in fact any type of income-producing asset, is for the income they represent. These are cash flow investments, which we buy, in the most general terms as least, because we are looking to replace or supplement our earned income.
That being said, it is reasonable that the value of an asset should be relative to the income-potential of this asset. The more money it makes, the more valuable it is – again, in the most basic terms.
How to Value 4 Units or Less
Owner-occupied property is treated very differently in the world of real estate from true investment property. The reason for this is because owner-occupied property financing options and mechanisms, which are obviously designed first and foremost, to accommodate owner-occupant, are very different from financing options available for investment property.
Most of the difference is in the fact that while residential paper (mortgages) are originated and then very quickly sold on the secondary market, commercial paper is most often retained on the books of the lender. For this reason, residential paper has to conform to the qualifying guidelines mandated by the secondary market, while commercial paper does not.
A lot more can be said about this (and I’ve talked about all of this in detail in the Cash Flow Freedom University), for now I just want to emphasize the impact of these financing differences, which is this:
Duplex, Triplex, and Fourplex can be Bought with Traditional Financing
As we previously discussed, owner-occupied property is valued via the CMA. And while most duplex, triplex, and four-plex are bought by investors strictly for investment purposes, nonetheless they are classified as owner-occupied type property according to secondary market guidelines. For this reason, owner-occupied type of financing is available for these. And, importantly, for this reason, the value of these is assessed very similarly to a straight-up SFR, meaning the value setting mechanism relies heavily on the CMA (read about the comparative market anaysis here).
Having said this, the secondary market understands that even though an owner-occupant may be buying this 4-plex to move into one of the units and call it primary residence, the fact that this leaves 3 other units in the property to be rented out means that at least some thought has to be given within the appraisal to the rents.
Gross Rent Multiplier Method
Valuation mechanism in the residential 4-plex and smaller is called Gross Rent Multiplier Method. The GRM method understands that value is a function of the income, in some shape or form, and chooses the Gross Income – this is the simplest type of income to consider, and it is the least accurate basis for valuation. But, in the residential space this doesn’t matter much, since the valuation methodology is 90% weighted toward the CMA anyhow.
However, since we’re talking about it:
Let’s say this 4-plex brings in $600/door, with total revenue of $2,400/month, or $28,800/annum. Knowing this you now ask the question:
How much would I pay for revenue of $28,800/annum?
Answering this question would lead you to some sort of basis of value. But, in order to be meaningful, what you really need is to know what other investors in this marketplace are seeing and achieving.
Gross Rent Multiplier Example
If you look at a comp which sold for $130,000, and you know that at the time it sold, the revenue totaled $23,000/year, then you can work the numbers backwards to understand what this investor was thinking:
Sold Price / Gross Income = Multiplier
$130,000 / $23,000 = 5.65
In this case, the Multiplier which represents a coefficient which the buyer was willing to deploy capital at, is 5.65…
If you look at another comp which sold for $145,000 and had revenue of $24,000, then you know that the multiplier in this case was 6.04…
Estimating Value with Gross Rent Multiplier (GRM)
These coefficients, otherwise known as Multipliers, point to the behavior in the marketplace. In this case, two investors were willing to deploy capital in the range 5.65 – 6.04 multiplier of gross rent. If you analyze a bunch of comps, and average somehow the multiplier, then you can arrive at an approximate dynamic in the marketplace.
For example, averaging these two numbers will give us a multiplier of about 5.75. And knowing this, you can now estimate the value of your subject 4-plex:
Value = Gross Income x Multiplier
Value = $28,800 x 5.75 = $165,600
And it appears that the subject which produces income of $28,800/annum should be valued at $165,600 in this marketplace.
GRM analysis is not very accurate. Why – because we don’t buy income property for how much rent it brings in. We buy income property for how much goes in our pocket after we pay the operating expenses. And, while GRM does indeed make an attempt to focus on the income, it focuses on the wrong type of income to be of any is to us investors.
However, if you are going to buy these small multis utilizing conforming financing, you should know how GRM approach works.