Price Rent Ratios

Asked by Graham M. Lombardo, Franklin, TN Tue Nov 20, 2007

Without getting to technical, how would one explain the Price/Rent Ratio evaluation indicator. For instance, if the ratio last year was 18, and currently it is 26, what does that mean? Thanks in advance.

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Jim Walker, Agent, Carmichael, CA
Thu Nov 22, 2007
If there is no change in annual rental income, as per my first example, it translated to a 44.4% price increase..
If there had been a 5% increase in the rent then the price increase is even greater. That duplex would be at $546,000 ( a 51.6% price increase)

If 14 is the normal gross rent multiplier for an area. Then the "normal" price would be $280,000 at a the lower income level and climb to $294,000 after the rent increases.

I have never met an investor who wanted to pay "normal" They all want it cheaper.

Translation of 18 to 26 ? Easy - Seller is asking twice what it is worth as an income producing investment. Disclaimer - the "market value" could be the asking price based on other factors such as underlying land value, development potential, suitability for owner occupant use, OR as was the case from 2003 through 2005 - Speculation based on the Bigger Fool Theory.

I will give an example where the using a "historical" GRM to derive that number could be flawed, in this second example the property is correctly valued, But the GRM was poorly communicated.

Fourplex was in need of major renovations, Entire building was vacant for most of the year.
Gross rental income was only $10,000 that year. Lisitng agent enters GRM based on last years rent as 26 because the price for the now fully renovated and fully leased building is $260,000.
The "pro forma" (expected gross rental income next year) is $26,000.
If the listing agent had entered the projected GRM it would have been 10 which is within the range of feasibility that warrants further number crunching.

At first read, you might think the LA made a mistake. However, the LA may have declined to advertise the projected GRM out of fear of being accused of misrepresentation by a buyer who does not subsequently obtain projected market rents.

Occasionally it is the property that is represented by an agent who is not an investment expert that is the gem you want to pick up. Such properties justify a thourough reading of the MLS data, rather than reliance on a single number as indicator.

If you have hundreds of properties to sift through, the GRM is an effective filter, with a few exceptions such as my second example.
2 votes
Mike Kelly A…, Agent, Santa Rosa, CA
Thu Nov 22, 2007
Graham, That's very interesting as I've not heard of GRM for years. I always thought it the lazy, or unsophisticated Realtor/Licensee's way of expressing value. Normally "cap" (capitalization rate) rates are used but in high market value areas they become an almost futile waste of time or at least a fun indice to throw out at a marketing meeting to hear the "gasps" of horror! Of course, I'm in the Bay Area of California and even classs A ofice space and large multi-family units have such low cap rates as to make the investment almost nonsensical! But folks keep snapping them up as many other factors enter into the equation as per value of these type of properies. Jim is right and one must always be wary of such quick "value" indices!
1 vote
Jim Walker, Agent, Carmichael, CA
Wed Nov 21, 2007
Gross Rent Multiplier is a "back of the envelope" short cut for evaluating listed income properties to determine if further analysis for more important numbers such as Capitalization Rate (Cap Rate) and IRR (Internal Rate of Return) and Debt Service Coverage Ratio (DSCR) and Cash-on-Cash should be calculated for a target acquisition.

In the example that Graham gave, I will expand the scenarion and presume that last year the duplex in question generated $20,000 in rental income per year and the price was $360,000.
Today, with no increase in annual income the seller is now asking $520,000.

Clearly, one need not waste another second analysing such a property for an investor seeking income.
The price may be justifiable for some other reason, such as it comes with a large amount of developable land or the duplex is on Rich Guy Lane, and it is suitable for owner occupancy, because it is so nice.
1 vote
Graham M. Lo…, Agent, Franklin, TN
Fri Nov 23, 2007
Thank you Michael and Jim!
0 votes
Graham M. Lo…, Agent, Franklin, TN
Thu Nov 22, 2007
Thanks Jim. I guess what I'm looking for answer wise is how the ratio translates. In otherwords, going from 18 to 26 means (?) I recently read an article listing regions of the country, and the Price/Rent Ratio was used to justify possibly why home prices were overpriced based on the comparable rent one could pay for similar properties. They used an index of 14 as being the norm. I was just trying to understand the signifigance of those numbers.
0 votes
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