The relevance and application of the gross income multiplier.
HISTORICAL PERSPECTIVE OF THE GROSS INCOME MULTIPLIER (GIM)
The concept of the GIM is neither new nor limited in its application to the valuation of real property. In the real estate valuation field, for example, reference was made to its use as long ago as 1740, when Thomas Miles offered a variation of the income multiplier method. He suggested in "A Hint of the Method of Valuing Ground and Houses," from his book, The Concise Practical Measurer: Or a Plain Guide to Gentlemen and Builders, that to estimate the present value of the land the current rental should be multiplied by a specified number of years.(1)
A similar process of valuation is referred to as the "multiple of gross rental process" by Frederick M. Babcock in his 1927 book, The Appraisal of Real Estate. According to Babcock, the multiple of gross rental process corresponds to the British method of computing residential real estate values as a constant multiple of the "Year's Purchase."(2) Stanley L. McMichael later included in his 1945 book a table that converted residential gross rental values to land values. This table was prepared by Cuthbert E. Reeves, of Buffalo, New York.(3)
In discussing gross rentals in his 1911 landmark book, Richard M. Hurd observed that the "basis of gross business rents |is~ what the property earns for the tenant" while the basis "of gross residence rents |is~ what the tenant can afford to pay. . . . The basis differs radically between business property which earns income for the occupant as well as the owner, and residence property, which for the occupant consumes income only."(4)
John A. Zangerle, in his 1924 book, criticizes the gross income method because it makes no allowance for vacancies. He further notes that "Apartment houses require such a large and varying allowance for depreciation and maintenance that a standard multiplier of rents becomes more difficult than in the case of detached residences."(5) He points out that "The amount of service given to tenants must be considered in determining which rate to use for any particular building."(6) His general estimate of annual multipliers for flats was about five and as low as four for elevator apartments and offices, while a monthly rent multiplier of about 100 was to be expected for residences. He made an observation that still applies in the current application of the rent multiplier technique, "It may be safer, in attempting to value some buildings on the basis of gross rental, to take, not the rents actually being received, but those which are recognized as the fair rents for similar space."(7)
Multipliers have changed over the years and even today can vary among locales, especially when supply and demand conditions change within the same market. A 1991/1992 rent survey conducted by the authors found that for single-family residential properties, 1) GRMs are comparatively higher for newer properties; 2) GRMs tend to increase as home prices increase, as shown in Figure 1; and 3) no discernible difference in GRMs was found between urban and suburban residences. The same survey revealed that for nonresidential property, GIMs tend to decrease as operating expense ratios increase.
RELATIONSHIP BETWEEN REAL ESTATE GIM AND PRICE/EARNINGS RATIO OF SECURITIES
A relationship can be drawn between the GIM and the price/earnings ratio, which is often used for stock valuation purposes. The price/earnings ratio of a company's stock is computed by dividing the market price of a share of its common stock by the company's earnings per share. For example, assume that in 1992 ABC Corporation earned $2.00 for each share of outstanding common stock and the current market price of its stock is $36.00. The price/earnings ratio for ABC Corporation is $36.00/$2.00 or 18. It can be said that the stock of ABC Corporation is selling at a multiple of 18 times its 1992 earnings.
In addition to its use in stock valuation, price/earnings ratio is considered by many security investors to be a good benchmark of value. As a benchmark, the price/earnings ratio is used in what is known as the value approach to investing, which was founded by Benjamin Graham. Ease of application and the ready availability of information in the marketplace are strong arguments for the use of the value approach to stock investing.
Similarly, while the use of a gross income multiplier in valuing real estate is simple and direct, some question its reliability as an indicator of value. Most of these arguments stem from the uncertainties as to what kind of multiplier is being used (i.e., potential or effective) and differences in properties with relation to such factors as size and age. In "Don't Underrate the Gross Income Multiplier," however, Richard Ratcliff argues that if properly used, the GIM is a reliable method of estimating market value.(8) He cites a University of California study that found that an income multiplier appeared in 77% of 84 income property appraisal reports prepared by leading appraisers. The study further found that, if these appraisers had relied only on a multiplier for their final values, the appraisals would have been within 1% of the appraised values. In addition, the authors' previously mentioned 1991/1992 survey of commercial and residential appraisers in the Richmond, Virginia, metropolitan area indicated that the majority of those surveyed use the GIM in conjunction with the traditional cost, sales comparison, and income approaches to value.
Perhaps one of the most compelling arguments for the use of the GIM is that it is a market-derived fact that does not rely on personal judgment or subjective conclusions. It takes into account, in one single ratio, all of the factors that market participants consider in pricing properties. Ratcliff also discusses a study in which he analyzed 385 sales of various types of residential rental properties in the Vancouver metropolitan area to test the reliability of the GIM for predicting market price.(9) Based on these 385 sales, Ratcliff established average GIMs for various types of residential rental properties. Using these average GIMs, Ratcliff was able to compare the predicted selling prices for these properties with their actual selling prices. The average difference between the two prices ranged from 4% to 8%.
Ratcliff was not content just to believe that a GIM is a reliable predictor of value; he wanted to know why the GIM is a reliable predictor. His answer is very simple. A GIM is used regularly by most participants in the real estate market. Although a GIM is usually not used for single-family residential properties because they seldom rent, rental data for most other types of properties are ordinarily available for analysis. A GIM is derived from past market data, which are generally available to all market participants. Therefore, the GIMs used by the different parties are for the most part constant across each market sector. If the decision making of participants is based on approximately the same GIM, it is fair to assume that the selling prices of properties within the same sector generally will have the same ratios. Because future decisions are based on past market activity, the GIM becomes a self-perpetuating ratio. Nevertheless, there may be sufficient variance in computed GIMs by property class to warrant close scrutiny of such data by real estate appraisers.
DISTINCTION BETWEEN GIM AND GROSS RENT MULTIPLIER (GRM)
In the past, and especially for residential property, the term GRM was favored. More recently, and primarily for nonresidential income property, the expression GIM has become popular. The term GIM is used because some properties generate income from non-rental sources. As Roger E. Cannaday notes in "A Systematic Framework for Alternative Methods of the Income Approach," the term "income" as opposed to the term "rent" implies that income other than rent may be derived from a property. These sources of income include, but are not limited to, parking fees, security deposits retained, and income from laundry facilities.(10) By contrast, the GRM applies to building rental income only. The term GRM is associated primarily with single-family residential properties. By convention, GRMs are expressed in monthly terms as opposed to annual multipliers, which are associated with nonresidential property. For example, a dwelling that rents for $500 per month and sold for $50,000 has a monthly gross rent multiplier of 100. Whether a GRM or a GIM is used in valuing a property is not as important as consistency of use. According to Cannaday, "One should use an income for the subject property that is consistent with that used for the comparable properties to derive the multiplier."(11)
At this point a distinction should be made between a PGIM and an EGIM. A PGIM expresses the relationship between the selling price of a property and the total income achievable by that property. The PGIM makes no allowance for vacancy and collection losses. An EGIM expresses the relationship between the selling price of a property and the annual income that is actually achieved by the property, taking into consideration such factors as vacancy and collection. It is important that an appraiser make a distinction between use of a PGIM and use of an EGIM. To appreciate the dangers inherent in using the PGIM and EGIM interchangeably, consider the following example:
Apartment Building Potential gross income $500,000 less vacancy and collection loss $ 25,000 Effective gross income $475,000 Sale price $2,500,000 PGIM $2,500,000/$500,000 = 5 EGIM $2,500,000/$475,000 = 5.3
If an appraiser uses this sale as a comparable, he or she must be careful to apply the appropriate multipliers to the subject property. If the appraiser inadvertently applies the EGIM for this comparable to the potential gross income of the subject, he or she could overestimate the value of the subject property in this example by 6%. As the spread between potential and effective gross income increases, so will the margin of error if the incorrect type of multiplier is chosen. The EGIM will tend to be greater than the PGIM because effective gross income generally is less than the potential gross income. When a smaller value (i.e., EGIM) is divided into a constant value (i.e., sale price), the result (i.e., income multiplier) in turn will be greater. The uncertainty as to whether a multiplier refers to potential income or effective income is one argument critics offer against the use of income multipliers.
PROS AND CONS OF RENT/INCOME MULTIPLIERS IN VALUING PROPERTY
Although the GIM can be a reliable value indicator when properly applied and interpreted, most practitioners will agree that the use of a GIM has both advantages and disadvantages. An understanding of the relative merits of a GIM can ensure that an appraiser practices proper discretion when using this method of valuation. A list of the advantages and disadvantages associated with the use of a GIM, in order of their perceived importance, follows.
1. The data required by the use of a GIM are available in and reflect the marketplace. This argument for the use of the GIM is considered most important because value of real estate is determined by the price a buyer in the market is willing to pay for the property or for a property with similar utility.
2. Multipliers are widely used in practical valuation. In Real Estate Appraisal Review & Outlook, Paul Wendt suggests that because GRMs are widely used, there is a tendency for sale prices to "adapt themselves to the relationships presumed by gross-income multipliers."(12)
3. Used and interpreted properly, the GIM method omits subjective processes and personal judgment, which are present in other valuation techniques. Wendt notes that some of the more subjective processes of estimation implicit in the income capitalization method are eliminated when multipliers are used.(13)
4. The GIM method is simpler and easier to understand than most other valuation methods.
5. The GIM method can be used to supplement the depreciated cost, sales comparison, and capitalized income approaches to value. Shenkel asserts that "The gross income multiplier constitutes a useful guide to weigh and evaluate other market evidence."(14)
6. Operating expense data typically are unavailable for single-family residential properties. Therefore, the GIM technique is quite applicable when only sale prices and gross rents are known.
The gross income method is not without its critics. Even advocates of the method take care to acknowledge the disadvantages of the method so that practitioners will take necessary precautions in using the GIM.
The disadvantages associated with the use of the GIM are listed below in order of perceived importance.
1. The GIM method assumes uniformity in properties across similar classes. Practitioners know from experience that expense ratios among properties within the same class can differ greatly as a result of such factors as deferred maintenance, property age, and quality of property management.
2. The GIM estimates value based on gross income and not NOI, while property is purchased based primarily on its net earning power. It is entirely possible that two properties can have the same NOI even though their gross incomes differ by as much as 100%. Thus, the GIM is subject to substantial misuse in the hands of an inexperienced appraiser or investor.
3. A GIM completely fails to account for the remaining economic life of comparable properties. By ignoring remaining economic life, a practitioner can assign equal values to a new property and a 50-year-old property, assuming they generate equal incomes.
The GIM appears in appraisal literature as early as the eighteenth century. GRMs generally are used for single-family residences, and unlike GIMs, exclude income from non-rental sources. PGIMs differ from EGIMs in that they are based on income before vacancy and collection losses are excluded; PGIMs consequently produce lower multipliers.
Compared with other valuation techniques, the multiplier method is advantageous because it is based on market transactions, omits subjective processes and personal judgment, and is easily understood. Conversely, the rent multiplier valuation technique may be flawed when applied to properties with different characteristics such as operating expense ratio or building age. Moreover, it is based on gross income rather than NOI, which generally is the basis for property purchases.
GRMs tend to increase as the prices of residences rise. Also, for nonresidential properties, it was found that GIMs tend to decrease as operating expense ratios increase. Studies show that the majority of appraisers use the income multiplier technique in valuing real estate. Further, this method has been found to be a reliable measure of real estate value.
1. James H. Boykin, "Real Property Appraisal in the American Colonial Era," The Appraisal Journal (July 1976): 370.
2. Frederick M. Babcock, The Appraisal of Real Estate (New York, New York: MacMillan Company, 1927), 203-204.
3. Stanley L. McMichael, McMichael's Appraising Manual, 3d ed. (New York, New York: Prentice Hall, Inc., 1945), 651.
4. Richard M. Hurd, Principles of City Land Value (New York, New York: The Record and Guide, 1911), 122.
5. John A. Zangerle, Principles of Real Estate Appraising (Cleveland, Ohio: Stanley McMichael Publishing Organization, 1924), 55-57.
8. Richard U. Ratcliff, "Don't Underrate the Gross Income Multiplier," The Appraisal Journal (April 1971): 264.
10. Roger E. Cannaday, "A Systematic Framework for Alternative Methods of the Income Approach," The Real Estate Appraiser (May 1991): 62.
12. Paul F. Wendt, Real Estate Appraisal Review & Outlook (Athens, Georgia: University of Georgia Press, 1974), 186.
13. Paul F. Wendt, Real Estate Appraisal: A Critical Analysis of Theory and Practice (New York, New York: Henry Holt and Company, 1956), 210.
14. William M. Shenkel, "Characteristics of Gross Income Multipliers," The Real Estate Appraiser & Analyst (January/February 1968): 30.
James H. Boykin, MAI, SRA, PhD, is the Alfred L. Blake Chair Professor of Real Estate at Virginia Commonwealth University. He received a PhD from American University, and is the author of numerous articles and books, including the fourth edition of The Valuation of Real Estate and the second edition of Financing Real Estate.
Margaret T. Gray is a commercial appraiser with Salzman Real Estate Services, Inc., in Richmond, Virginia, and specializes in the appraisal of shopping centers, offices, and multifamily properties. She received an MBA with a concentration in real estate and urban land development from Virginia Commonwealth University and is a chapter representative to the Young Advisory Council of the Appraisal Institute.
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|Author:||Boykin, James H.; Gray, Margaret T.|
|Date:||Apr 1, 1994|
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