WEBVTT

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Welcome back to The Deep Dive. I want to start

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today with a visual. Okay. You know that scene,

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it's in every high stakes business movie, right?

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The one where the seasoned tycoon is sitting

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in a diner, maybe a boardroom. Smokey back room.

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Exactly. And someone slides this huge thick binder

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across the table. It's got hundreds of pages

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of due diligence, property inspections, tax records,

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everything. But the tycoon, they don't even open

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it. Instead, they just ask one question. Maybe

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they scribble a single number on the back of

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a cocktail napkin. And then they look up and

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they say, I'm in. Or the opposite. You're out

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of your mind. Or even more dramatically, you're

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out of your mind. Exactly. And for the longest

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time, I thought that was just, well, I thought

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it was lazy screenwriting. The classic Hollywood

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trope of the gut feeling. The idea that... You

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know, the true experts have some kind of sixth

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sense that just cuts through all the paperwork.

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Yes. A superpower that you're either born with

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or you're not. But I've recently been sort of

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wading into the weeds of real estate investing,

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just dipping my toes in. I realized something.

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What's that? That napkin math isn't a superpower.

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It's an actual mechanic. There are specific tools

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designed to let you look at a price tag and almost

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instantly know if a deal is a total ripoff or,

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you know, a potential gold mine. It feels like

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magic, but it's really just a ratio. Right. But

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it feels like a cheat code. And today we are

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talking about one of those specific cheat codes.

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It's called the gross rent multiplier. Or GRM

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for short. And you're right to call it a cheat

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code. but maybe not the way you think a cheat

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code in a video game it lets you skip the hard

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levels right gross rent multiplier it lets you

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skip the noise but and this is the big but we're

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going to spend the next hour unpacking if you

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use it blindly it can also lead you right off

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a cliff that is the mission for today we have

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a stack of sources here Technical definitions,

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some valuation principles and a few cautionary

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tales. And we are going to just completely dissect

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the gross rent multiplier. We want to move beyond

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just staring at a Zillow listing and seeing a

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price that looks like a telephone number. Right.

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We want to understand the relationship between

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what a building costs and what it actually earns.

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And we need to go deeper than just. How to divide

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X by Y. I mean, any calculator can do division.

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Right. We need to understand the sort of the

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psychology of this metric. Why do sellers love

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it? Why do buyers get tricked by it? And how

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does it stack up against the adult tools in the

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room like cap rate and discounted cash flow?

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So we're going from the back of the napkin scribble

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to the why am I losing money on this duplex?

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That is the trajectory, yes. Okay. So let's start

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with the absolute basics, but I want to frame

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it practically. I'm scrolling through listings.

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I see a duplex. It's $500 ,000. Okay. Then I

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see another one down the street for $450 ,000.

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My brain, my immediate gut reaction says the

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$450 ,000 one is cheaper. But that's not necessarily

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true, is it? No, not at all. Because you aren't

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buying the bricks and the mortar. You're buying

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the income stream that comes with it. That $450

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,000 building might have tenants who are paying,

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you know, 1990s rent prices. The $500 ,000 building

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might be fully optimized, getting top market

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dollar. So price alone, it's a completely useless

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metric. You need a bridge. You need a bridge

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between the price and the income. Yeah, exactly.

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And that bridge is the gross rent multiplier.

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So if I stopped a real estate mogul on the street

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assuming they wouldn't call security on you right

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assuming that doesn't happen and i asked for

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the plain english definition what is it in the

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simplest terms the gross rent multiplier is the

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ratio of the price of a real estate investment

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to its effective gross income okay stop right

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there you threw a specific term in immediately

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Effective gross income. Now, I know what income

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is. That's the rent checks coming in. But why

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gross and why effective? That's a key distinction.

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It is. This is the first hurdle where people

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get tripped up. When we say gross income in the

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context of GRM, we're talking about the absolute

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top line revenue. We're talking about the money

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coming in the door before a single cent goes

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out the door. So before I pay the property tax

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bill. Yes. Before I pay the insurance policy

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for the year. Yep. Before that. Before I pay

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the water bill. The trash collection? The guy

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who mows the lawn? Before all of that, when you

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calculate GRM, you are deliberately, consciously

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ignoring operating expenses. Okay, hold on. That

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sounds incredibly dangerous. It does. I mean,

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if I'm evaluating any other business, I care

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about profit. I care about what I actually keep

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in my pocket. So if I'm looking at a property

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and I explicitly ignore the taxes and the insurance,

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isn't that just financial suicide? How can that

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possibly be a valid way to value something? It

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does sound reckless, doesn't it? Here, buy this

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business, but whatever you do, don't look at

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the costs. Right. But think about the napkin

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scenario you started with. You're at the diner.

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You don't have the tax bill in front of you.

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You don't have the insurance quote yet. You need

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a way to filter the deal now with the limited

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information you have. So it's a filter. It's

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just a first glance tool. Exactly. But there's

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a conceptual way to look at it that makes it

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a little less scary. Try thinking of the GRM

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not as a measure of profit. But as a measure

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of time. Time. How so? Yes. The number you get

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when you calculate the GRM, it actually represents

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the number of years the property would take to

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pay for itself using only the gross received

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rent. Okay. Let me try to visualize that. So

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I buy a building. I take every single rent check

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I receive and I just stack them in a big pile

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in the corner. I don't pay the mortgage. I don't

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fix the leaky toilet. I don't pay the government

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their taxes. I just stack the cash. You just

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stack the cash. The GRM is how long it takes

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until that stack of cash is the same height as

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the purchase price. That is the perfect way to

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picture it. It is a raw, unadjusted payback period.

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So following that logic, if it's a measure of

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time, then faster is obviously better. I want

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my money back now, not in 100 years. Precisely.

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That is the golden rule of the GRM. For a prospective

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investor, a lower GRM represents a better opportunity.

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Because it just means fewer years to pay off

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the initial investment. Correct. If you see a

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listing with a GRM of five and another one with

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a GRM of 20, strictly on a payback basis, the

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five is paying you back four times faster. But,

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and I'm going to play the skeptic here again.

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If I see a GRM of five, which sounds amazing,

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right, paid off in five years, shouldn't I be

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suspicious? You absolutely should. I mean, if

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a building can pay for itself in five years,

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why on earth is the seller getting rid of it?

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Ah, now you are thinking like an investor. A

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very low GRM can be a sign of a fantastic deal,

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but it is often a sign of a war zone. What do

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you mean? It might mean the area is so risky

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that investors demand a super fast payback because

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they don't know if the building will still be

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standing or rentable in 10 years. Ah, so a low

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number draws you in, but it might just be a trap.

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It's a signal. That's all it is. It's a signal

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to look closer. But before we get into all the

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traps, and believe me, there are many, we need

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to ground this in reality. I want to move away

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from the abstract. Let's actually do the math.

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Agreed. I need to see the gears turning. I have

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a specific example from our source material right

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here. And for you, the listener, I want you to

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imagine you're standing on the sidewalk. You're

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looking at a nice little rental house, white

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picket fence, maybe a little garden out front.

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Okay, I'm there. The sign in the yard, or maybe

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the listing on your phone, says the sale price

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is $200 ,000. $200 ,000. Got it. You talk to

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the agent, or maybe you peek at the current.

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lease agreement that they've provided. And you

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see that the current tenant is paying $750 per

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month. All right. So we have our two key pieces

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of data, the price, which is $200 ,000, and our

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monthly rent, $750. Now, my first instinct. My

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bad math instinct is to just grab my phone and

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divide $200 ,000 by $750. Stop. Do not do that.

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Why not? Because you're dividing an apple by

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an orange. You're dividing a capital sum, the

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total price of the asset, by a monthly flow.

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The units don't match up. What happens if I do

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it anyway? If you do that, you get, what, $266?

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Yeah, $266 .6. A GRM of 266 would imply it takes

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266 years to pay off the building. If you see

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that number, you're going to run away screaming.

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You have to annualize the rent first. GRM is

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an annual metric. Okay. Okay. That makes sense.

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You have to compare years to years. So step one,

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turn the monthly rent into a yearly number. We

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take that $750 a month and we multiply it by

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12 months. Right. Let's do some mental math.

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750 times 10 is 7 ,500. Right. 750 times 2 is

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1 ,500. Add them up, you get 9 ,000. So this

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little house brings in $9 ,000 a year in gross

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rent. Exactly. Now we can do the division. Now

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the units match. We take the price, the $200

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,000, and divide it by that annual rent, the

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$9 ,000. Okay, I'm punching that into my calculator

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now. 200 ,000 divided by 9 ,000. And the calculator

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gives me 22 .22. There you have it. The GRM for

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this property is 22 .22. So let's unpack that

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result. 22 .22. In the vacuum of space, that's

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just a number. But based on our payback period

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definition, this means it takes roughly 22 .2

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years of gross rent to cover the purchase price.

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Yes, that's the interpretation. I have to be

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honest. 22 years feels like a really long time.

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I mean, I'll be significantly older in 22 years.

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And that's assuming I don't spend a single dime

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on repairs. If I actually have to replace the

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roof or fix the furnace, it might take 30 years.

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It is a significant amount of time. And this

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is where market context is everything. In a high

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appreciation market like, say, downtown Los Angeles

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or Manhattan. A GRM of 22 might actually be considered

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normal, maybe even good. Why? Because investors

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there aren't just buying for the rent checks.

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They're buying because they think the building

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will be worth $400 ,000 in five years. They are

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banking on appreciation. So a high GRM is often

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a signal that people are betting on the property

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value itself going up. Or the flip side is it

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means this property is just plain overpriced

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relative to what it earns today. It can be one

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or the other. And conversely. If I'm in, let's

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say, a sleepy town in the Midwest where prices

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never really change much. Right. A cash flow

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market. A GRM of 22 would be terrible. I'd want

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something much lower, closer to, what, 8, 10.

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In a pure cash flow market, absolutely. You'd

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want to see a GRM of 6, 8, maybe 10. You want

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that money back fast because you can't count

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on the building doubling in value overnight.

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So the number 22 .22 isn't inherently good or

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bad. It just gives me a benchmark. Exactly. I

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can now look at the house next door. If the house

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next door is also earning $9 ,000 a year, but

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it's selling for only $100 ,000. Then its GRM

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is roughly $11 ,000. $100 ,000 divided by $9

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,000. And suddenly the $200 ,000 house looks

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ridiculous. Exactly. And you didn't need to see

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the tax bill or the insurance statement to know

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that. You just compared the multipliers. That

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is the power of the shortcut. But and there's

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always a but with these shortcuts, isn't there?

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We touched on a trap a moment ago when I almost

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divided by the monthly rent. I want to double

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click on that because our source material really

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highlights this as a major point of confusion

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for new investors. The whole monthly versus annual

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trap. This is where rookies get embarrassed or

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worse. They make really bad offers. The source

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material says that historically and apparently

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in some circles, even today, people do, quote.

00:11:44.590 --> 00:11:49.039
based on monthly rent. Yes. It's much rarer now

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in professional circles, but it absolutely happens.

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Sometimes you'll see an old school broker who

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just says something like, oh, this place is trading

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at 100 times rent. 100 times rent. That sounds

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catchy. I'll give them that. It does. But he

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means 100 times monthly rent. OK, so let's look

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at the math conversion that's provided in the

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source. It gives a very specific example. It

00:12:07.179 --> 00:12:11.100
says a GRM of 100 calculated on monthly rents

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is actually equal to an 8 .33 GRM calculated

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on annual rents. Right. Let's break that down

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so it's crystal clear. If someone says the GRM

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is 100 based on those monthly numbers, they mean

00:12:23.639 --> 00:12:26.179
the price is equal to 100 months of rent. Okay,

00:12:26.299 --> 00:12:28.399
100 months of rent. Yeah. So how many years is

00:12:28.399 --> 00:12:31.899
100 months? You just divide 100 by 12. And that

00:12:31.899 --> 00:12:36.000
gets you 8 .333 repeating. Exactly. So if you're

00:12:36.000 --> 00:12:38.980
looking at a deal and you see GRM 100 and you

00:12:38.980 --> 00:12:41.679
panic, thinking 100 years to pay this thing back.

00:12:43.640 --> 00:12:45.860
You've just misunderstood the unit of measurement.

00:12:45.919 --> 00:12:49.779
It's actually an 8 .33 year payback, which is

00:12:49.779 --> 00:12:52.940
quite good. And the reverse is true, too. If

00:12:52.940 --> 00:12:57.379
I see a GRM of 8 .33 on a flyer and I just assume

00:12:57.379 --> 00:12:59.639
it must be monthly. You'd think, wow, the house

00:12:59.639 --> 00:13:01.720
costs just eight months of rent. I'll take 10

00:13:01.720 --> 00:13:03.580
of them. Right. In our example, that would be

00:13:03.580 --> 00:13:08.230
an 8 times 750. A $6 ,000 house. Exactly. So

00:13:08.230 --> 00:13:10.389
context clues usually save you here. If the number's

00:13:10.389 --> 00:13:12.690
up in the hundreds, it's almost certainly a monthly

00:13:12.690 --> 00:13:15.049
figure. If it's in the single or low double digits,

00:13:15.190 --> 00:13:17.909
it's annual. But the big takeaway is never assume.

00:13:18.190 --> 00:13:20.470
Just ask the question, are we talking monthly

00:13:20.470 --> 00:13:22.750
or annual? Because the difference is a factor

00:13:22.750 --> 00:13:25.350
of 12. And in finance, being off by a factor

00:13:25.350 --> 00:13:27.929
of 12 is the difference between retiring early

00:13:27.929 --> 00:13:30.049
and going completely bankrupt. Okay, so we've

00:13:30.049 --> 00:13:33.909
got the math down. We understand the 22 .22 figure

00:13:33.909 --> 00:13:36.409
we know to always use annual rent. But I want

00:13:36.409 --> 00:13:39.590
to go back to this uniformity issue. I'm still

00:13:39.590 --> 00:13:41.629
stuck on the idea that we're just ignoring all

00:13:41.629 --> 00:13:44.129
the expenses. You said earlier that it works

00:13:44.129 --> 00:13:46.629
because of uniformity. I need you to convince

00:13:46.629 --> 00:13:48.769
me because my skepticism meter is still kind

00:13:48.769 --> 00:13:51.370
of redlining on this. Fair enough. Let's try

00:13:51.370 --> 00:13:53.889
a different analogy. Imagine you're buying a

00:13:53.889 --> 00:13:57.649
used car. You're looking at two absolutely identical

00:13:57.649 --> 00:14:00.769
Toyota Camrys. Same year, same mileage, same

00:14:00.769 --> 00:14:02.710
condition. They're parked right next to each

00:14:02.710 --> 00:14:05.389
other. Okay, I can picture that. Do you need

00:14:05.389 --> 00:14:08.269
to calculate the exact cost of gasoline for the

00:14:08.269 --> 00:14:10.750
next five years to figure out which car is the

00:14:10.750 --> 00:14:13.360
cheaper one to buy? No. Of course not, because

00:14:13.360 --> 00:14:15.500
they get the same gas mileage. The gas cost is

00:14:15.500 --> 00:14:17.659
going to be the same for both of them. Exactly.

00:14:17.820 --> 00:14:21.580
The gas is uniform. So you can safely ignore

00:14:21.580 --> 00:14:23.480
it for the comparison and just look at the sticker

00:14:23.480 --> 00:14:26.500
price. That is a fundamental argument for using

00:14:26.500 --> 00:14:29.299
GRM in real estate. So if I'm looking at two

00:14:29.299 --> 00:14:32.120
nearly identical apartment buildings and they're

00:14:32.120 --> 00:14:34.419
on the same street. Right. They're in the same

00:14:34.419 --> 00:14:36.399
county, so the property tax rate is going to

00:14:36.399 --> 00:14:38.720
be the same percentage for both. They were likely

00:14:38.720 --> 00:14:41.080
billed around the same time with similar materials,

00:14:41.179 --> 00:14:43.480
so the insurance risk is probably pretty similar.

00:14:43.700 --> 00:14:45.580
The tenants in that neighborhood, they probably

00:14:45.580 --> 00:14:48.159
all pay their own electric bills. So the overall

00:14:48.159 --> 00:14:50.679
expense profile is roughly identical between

00:14:50.679 --> 00:14:54.529
the two. That's the assumption, exactly. If building

00:14:54.529 --> 00:14:59.090
A uses, say, 40 % of its gross income for expenses,

00:14:59.490 --> 00:15:02.870
then building B probably uses about 40 % too.

00:15:03.330 --> 00:15:05.570
So if you just compare the top line numbers,

00:15:05.830 --> 00:15:08.470
the gross income, the ratio holds true. You don't

00:15:08.470 --> 00:15:10.669
need to do the heavy lifting of calculating the

00:15:10.669 --> 00:15:12.710
net income to know which one is the better relative

00:15:12.710 --> 00:15:14.570
value. Okay, that makes sense. It's a relative

00:15:14.570 --> 00:15:16.690
tool, not an absolute one. I'm not saying this

00:15:16.690 --> 00:15:19.029
is a good deal. I'm saying this is a better deal

00:15:19.029 --> 00:15:21.429
than that one. You've got it. It is useful for

00:15:21.429 --> 00:15:23.669
comparing properties where those operating expenses

00:15:23.669 --> 00:15:26.769
are expected to be uniform. Our source material

00:15:26.769 --> 00:15:29.269
lists specific things that we can often consider

00:15:29.269 --> 00:15:34.029
uniform. Depreciation effects, periodic costs

00:15:34.029 --> 00:15:37.309
like taxes and insurance, and any tenant -incurred

00:15:37.309 --> 00:15:39.610
utilities. But what happens when they aren't

00:15:39.610 --> 00:15:42.940
uniform? What if I'm comparing a brand new building

00:15:42.940 --> 00:15:45.940
with, you know, super efficient HVAC and new

00:15:45.940 --> 00:15:48.320
windows to a hundred year old building with a

00:15:48.320 --> 00:15:51.159
leaking boiler and drafty single pane windows?

00:15:51.519 --> 00:15:55.220
That is where GRM breaks completely and utterly

00:15:55.220 --> 00:15:57.600
breaks down. Because the expense profile is totally

00:15:57.600 --> 00:15:59.879
different. Wildly different. The old building

00:15:59.879 --> 00:16:02.399
might have a great GRM on paper. Maybe it's cheap

00:16:02.399 --> 00:16:04.840
and has high rent. But if 60 percent of that

00:16:04.840 --> 00:16:06.600
rent is going straight to the gas company to

00:16:06.600 --> 00:16:09.019
run that ancient boiler and to pay for constant

00:16:09.019 --> 00:16:13.019
repairs, the GRM. is lying to you about its profitability.

00:16:13.440 --> 00:16:16.500
So GRM is blind to efficiency. It is blind to

00:16:16.500 --> 00:16:18.679
condition. It's blind to the quality of management.

00:16:18.820 --> 00:16:20.919
It's blind to everything except for two numbers,

00:16:21.100 --> 00:16:23.519
the price and the rent. So why do we use it?

00:16:23.620 --> 00:16:25.919
I mean, really, if it's blind to all the things

00:16:25.919 --> 00:16:28.259
that actually cost me money, why not just always

00:16:28.259 --> 00:16:30.960
use the net income? Why ever bother with GRM?

00:16:31.059 --> 00:16:34.360
Because getting the net data is hard. And frankly,

00:16:34.580 --> 00:16:36.820
it's often unreliable when you're getting it

00:16:36.820 --> 00:16:38.960
from a seller. Is it? I mean, isn't it just on

00:16:38.960 --> 00:16:41.059
a spreadsheet somewhere? Think about the seller's

00:16:41.059 --> 00:16:43.519
motivation. They want to sell the building for

00:16:43.519 --> 00:16:46.720
the highest possible price. Do you think they're

00:16:46.720 --> 00:16:49.860
going to proudly advertise that they spent $15

00:16:49.860 --> 00:16:54.139
,000 fixing a major sewage backup last year?

00:16:54.419 --> 00:16:56.740
Probably not. They'd probably call that a one

00:16:56.740 --> 00:16:58.759
-time capital expenditure and try to hide it

00:16:58.759 --> 00:17:02.379
or explain it away. Or maybe the owner manages

00:17:02.379 --> 00:17:04.480
the building themselves to save money so they

00:17:04.480 --> 00:17:06.779
don't list a management fee expense. But you,

00:17:06.980 --> 00:17:09.400
the buyer, you live three states away and you're

00:17:09.400 --> 00:17:11.160
definitely going to have to hire a manager. Right.

00:17:11.220 --> 00:17:13.220
So their net income from last year is going to

00:17:13.220 --> 00:17:15.759
be artificially higher than my net income will

00:17:15.759 --> 00:17:18.559
be next year. Exactly. Net income is a slippery

00:17:18.559 --> 00:17:21.359
number. It depends heavily on who is running

00:17:21.359 --> 00:17:23.059
the building and how they account for things.

00:17:23.319 --> 00:17:26.279
Ah, but gross rent. But gross rent is usually

00:17:26.279 --> 00:17:28.690
a bit more public. You can look on Zillow or

00:17:28.690 --> 00:17:30.609
Craigslist to see what similar units are renting

00:17:30.609 --> 00:17:34.329
for. You can in theory ask the tenants. It's

00:17:34.329 --> 00:17:36.369
a harder number for a seller to completely fudge.

00:17:36.549 --> 00:17:39.670
And our source makes this point. Costs like repairs

00:17:39.670 --> 00:17:42.289
are often harder to predict than the market rental

00:17:42.289 --> 00:17:46.630
return. So GRM serves as an alternative when

00:17:46.630 --> 00:17:49.069
a true measure of net investment return is just

00:17:49.069 --> 00:17:51.950
too difficult or unreliable to determine. It's

00:17:51.950 --> 00:17:54.230
the quick and dirty tool. It's the tool you use

00:17:54.230 --> 00:17:56.170
when you don't fully trust the seller's expense

00:17:56.170 --> 00:17:58.190
report. Or when you don't have it yet. It's the

00:17:58.190 --> 00:18:00.230
scout that goes out ahead of the main army to

00:18:00.230 --> 00:18:02.369
survey the terrain. Okay, I like that analogy.

00:18:02.710 --> 00:18:06.250
The GRM is the scout. But eventually the army

00:18:06.250 --> 00:18:08.509
has to arrive. Eventually you have to look at

00:18:08.509 --> 00:18:10.990
the real profit. Yes. And that brings us to the

00:18:10.990 --> 00:18:13.819
big rivalry in real estate math. Section five,

00:18:14.079 --> 00:18:17.279
GRM versus the cap rate. This is the heavyweight

00:18:17.279 --> 00:18:19.059
championship. If you hang around real estate

00:18:19.059 --> 00:18:21.380
investors, you will hear the term cap rate 10

00:18:21.380 --> 00:18:24.759
times for every one time you hear GRM. Oh, yeah.

00:18:24.839 --> 00:18:26.960
What's the cap on that? I'm looking for a six

00:18:26.960 --> 00:18:29.619
cap. Sounds very sophisticated. So how does this

00:18:29.619 --> 00:18:32.200
relate to our humble little gross rent multiplier?

00:18:32.799 --> 00:18:35.180
They're effectively siblings, but one is the

00:18:35.180 --> 00:18:37.980
optimist and one is the realist. OK. The GRM,

00:18:38.099 --> 00:18:40.160
as we've established, is based on gross rental

00:18:40.160 --> 00:18:43.019
income. It ignores all the bad stuff. The cap

00:18:43.019 --> 00:18:45.500
rate or capitalization rate is based on net return.

00:18:45.640 --> 00:18:48.700
So cap rate does include the expenses. Yes. The

00:18:48.700 --> 00:18:51.119
formula for cap rate is the net operating income

00:18:51.119 --> 00:18:54.799
or NOI divided by the price. It peels back all

00:18:54.799 --> 00:18:57.839
those layers of taxes, insurance and maintenance

00:18:57.839 --> 00:19:00.539
to see the real profit yield of the property.

00:19:00.759 --> 00:19:02.440
There's also a structural difference. in how

00:19:02.440 --> 00:19:05.140
the number is expressed, right? GRM is a multiplier,

00:19:05.460 --> 00:19:08.740
a number like 10 or 12. Cap rate is always a

00:19:08.740 --> 00:19:11.660
percentage like 5 % or 8%. Right. And this is

00:19:11.660 --> 00:19:14.000
another thing that confuses people. One is a

00:19:14.000 --> 00:19:16.339
timeline, how many years to pay back. The other

00:19:16.339 --> 00:19:19.109
is a yield. What percentage return am I getting

00:19:19.109 --> 00:19:20.910
on my money this year? Is there a mathematical

00:19:20.910 --> 00:19:23.130
link between them? Or are they just two totally

00:19:23.130 --> 00:19:26.009
separate universes of metrics? Oh, they are deeply

00:19:26.009 --> 00:19:28.750
connected. In fact, our source points out that

00:19:28.750 --> 00:19:31.710
a multiplier derived from net return would be

00:19:31.710 --> 00:19:34.049
the multiplicative inverse of the cap rate. Whoa,

00:19:34.309 --> 00:19:37.630
okay, multiplicative inverse. You just lost half

00:19:37.630 --> 00:19:38.970
the audience with that one. You're going to have

00:19:38.970 --> 00:19:41.049
to unpack that without the textbook. Let's try

00:19:41.049 --> 00:19:44.579
an analogy. Think of a seesaw. On one side of

00:19:44.579 --> 00:19:46.859
the seesaw, you have the cap rate, which is your

00:19:46.859 --> 00:19:49.420
return. On the other side, you have the multiplier,

00:19:49.720 --> 00:19:52.319
which is the cost in years. Okay, I'm with you.

00:19:52.400 --> 00:19:56.200
Seesaw. If the return goes UP, meaning the deal

00:19:56.200 --> 00:19:58.460
is more profitable and you're making more money,

00:19:58.660 --> 00:20:01.059
what happens to the time it takes to get your

00:20:01.059 --> 00:20:04.160
investment back? The time goes down. If I make

00:20:04.160 --> 00:20:06.309
more money each year... I get paid back faster.

00:20:06.589 --> 00:20:09.849
Exactly. So as the cap rate goes UP, the multiplier

00:20:09.849 --> 00:20:12.250
goes down. They always move in opposite directions.

00:20:12.569 --> 00:20:15.150
Give me some actual numbers. Okay. Let's say

00:20:15.150 --> 00:20:18.650
you have a property with a cap rate of 10%. That

00:20:18.650 --> 00:20:20.809
means you are earning 10 % of your initial investment

00:20:20.809 --> 00:20:24.089
back every single year in pure profit. Simple

00:20:24.089 --> 00:20:26.549
enough. So if you earn 10 % a year, how many

00:20:26.549 --> 00:20:29.109
years does it take to get 100 % of your money

00:20:29.109 --> 00:20:32.859
back? 10 years. 10 times 10 % is 100%. Exactly.

00:20:32.859 --> 00:20:35.279
So a 10 % cap rate is mathematically equivalent

00:20:35.279 --> 00:20:38.220
to a net multiplier of 10. Now, what if the cap

00:20:38.220 --> 00:20:41.119
rate is only 5 %? Well, if I only make 5 % a

00:20:41.119 --> 00:20:44.660
year, it's going to take me twice as long, 20

00:20:44.660 --> 00:20:47.619
years to get to 100%. So a 5 % cap rate is a

00:20:47.619 --> 00:20:50.559
net multiplier of 20. Do you see the seesaw?

00:20:50.759 --> 00:20:54.059
The rate got cut in half from 10 to 5, and the

00:20:54.059 --> 00:20:56.650
time doubled. From 10 to 20. That is actually

00:20:56.650 --> 00:20:59.170
a really helpful visualization. There's just

00:20:59.170 --> 00:21:00.970
two different ways of asking the same fundamental

00:21:00.970 --> 00:21:04.089
question. One asks, how much cash do I get this

00:21:04.089 --> 00:21:06.789
year? And the other asks, how long until I'm

00:21:06.789 --> 00:21:09.369
whole? With the major, major caveat, of course,

00:21:09.450 --> 00:21:12.049
that GRM uses the gross numbers and cap rate

00:21:12.049 --> 00:21:14.470
uses the net numbers. So they will never match

00:21:14.470 --> 00:21:16.589
up perfectly in the real world. Right. But the

00:21:16.589 --> 00:21:19.190
relationship holds. If you see a property with

00:21:19.190 --> 00:21:21.750
a low GRM, you should expect to see a high cap

00:21:21.750 --> 00:21:24.329
rate. If you see a high GRM, you should expect

00:21:24.329 --> 00:21:26.750
a low cap rate. And what if you see a low GRM

00:21:26.750 --> 00:21:29.029
and a low cap rate? Then the expenses are enormous

00:21:29.029 --> 00:21:31.569
and you should run away as fast as you can. Right.

00:21:31.869 --> 00:21:33.430
That would mean the building brings in a lot

00:21:33.430 --> 00:21:35.630
of rent, but it costs an absolute fortune to

00:21:35.630 --> 00:21:38.130
run, so there's no profit left. Precisely. That's

00:21:38.130 --> 00:21:40.410
why you have to look at both. The scout reports

00:21:40.410 --> 00:21:43.150
back, then the Army does its own analysis. Now,

00:21:43.150 --> 00:21:46.029
speaking of looking at the numbers, we need to

00:21:46.029 --> 00:21:47.970
talk about where the numbers themselves come

00:21:47.970 --> 00:21:51.170
from. Because this brings us to Section 6, variations

00:21:51.170 --> 00:21:53.990
on the theme. And this, I think, is where most

00:21:53.990 --> 00:21:55.910
people actually lose their money. You're talking

00:21:55.910 --> 00:21:58.410
about the data source problem. It's a huge issue.

00:21:58.630 --> 00:22:01.910
Yes. First, a quick terminology check. I've seen

00:22:01.910 --> 00:22:05.309
the term Jim Gross income multiplier. Is that

00:22:05.309 --> 00:22:08.470
different from GRM? Not really. For our purposes,

00:22:08.670 --> 00:22:11.730
GRM and GIM are used essentially interchangeably.

00:22:12.150 --> 00:22:15.250
Sometimes income in GIM is meant to imply other

00:22:15.250 --> 00:22:17.890
sources of income, like laundry money or vending

00:22:17.890 --> 00:22:20.210
machines in an apartment building, but usually

00:22:20.210 --> 00:22:22.490
it's the same math. Okay, so GIM is fine. We

00:22:22.490 --> 00:22:24.529
don't need to worry about that. But the real

00:22:24.529 --> 00:22:26.670
danger is the difference between gross potential

00:22:26.670 --> 00:22:30.009
rent and effective gross income. This is the

00:22:30.009 --> 00:22:33.390
classic used car salesman tactic of real estate.

00:22:33.569 --> 00:22:35.170
Explain the difference between those two terms.

00:22:35.349 --> 00:22:38.250
Gross potential rent is the fantasy number. It

00:22:38.250 --> 00:22:40.910
is the absolute total possible rent you could

00:22:40.910 --> 00:22:44.009
collect if every single unit was full, every

00:22:44.009 --> 00:22:47.009
tenant was paying the top market rate, and nobody

00:22:47.009 --> 00:22:49.289
ever moved out or stopped paying. It assumes

00:22:49.289 --> 00:22:54.170
100 percent occupancy, 365 days a year. It's

00:22:54.170 --> 00:22:56.269
the in a perfect world number. It is. It's like

00:22:56.269 --> 00:22:59.309
a car manufacturer saying this car can get 50

00:22:59.309 --> 00:23:01.569
miles per gallon if you only drive it downhill

00:23:01.569 --> 00:23:04.069
with a tailwind. Right. So what is effective

00:23:04.069 --> 00:23:07.650
gross income? That is reality. That is the actual

00:23:07.650 --> 00:23:10.289
rent that was collected and deposited in the

00:23:10.289 --> 00:23:13.190
bank. It accounts for vacancies. It accounts

00:23:13.190 --> 00:23:15.829
for the fact that Unit 3B was empty for a month

00:23:15.829 --> 00:23:18.490
between tenants. It accounts for bad debt, the

00:23:18.490 --> 00:23:20.549
guy in 2A who just stopped paying his rent three

00:23:20.549 --> 00:23:22.930
months ago. So let's play this out. I'm a seller.

00:23:23.069 --> 00:23:26.130
I want my property's GRM to look as low as possible

00:23:26.130 --> 00:23:28.750
because we said low is good for a buyer. Which

00:23:28.750 --> 00:23:30.549
rent number am I going to use in my calculation?

00:23:30.890 --> 00:23:32.839
You are going to use the potential rent. Every

00:23:32.839 --> 00:23:35.180
single time. Because it's a bigger number. Right.

00:23:35.240 --> 00:23:37.519
A bigger denominator means a smaller result in

00:23:37.519 --> 00:23:39.920
the final division. Exactly. Let's say the price

00:23:39.920 --> 00:23:43.220
is $1 million. The actual effective rent collected

00:23:43.220 --> 00:23:47.640
was $100 ,000. The real GRM is 10. Okay. A GRM

00:23:47.640 --> 00:23:50.559
of 10. That's pretty decent. But the seller on

00:23:50.559 --> 00:23:53.220
their marketing flyer says, oh, but if you fixed

00:23:53.220 --> 00:23:55.720
up the basement and rented it out and you raised

00:23:55.720 --> 00:23:58.039
rents on everyone else to the absolute maximum,

00:23:58.299 --> 00:24:02.529
the... Potential rent is $200 ,000. So they take

00:24:02.529 --> 00:24:04.869
the $1 million price and divide it by their fantasy

00:24:04.869 --> 00:24:08.960
$200 ,000 rent. which gives a GRM of five. And

00:24:08.960 --> 00:24:11.579
suddenly the deal looks absolutely amazing. A

00:24:11.579 --> 00:24:14.779
GRM of five. I have to buy this. But I'm buying

00:24:14.779 --> 00:24:17.279
a fantasy. You are paying real money today for

00:24:17.279 --> 00:24:19.980
imaginary rent that might never materialize.

00:24:20.460 --> 00:24:23.400
Mixing these two up leads to catastrophic valuations.

00:24:23.559 --> 00:24:26.680
The source is very clear. You must observe multiples

00:24:26.680 --> 00:24:29.099
at comparable properties that have actually sold

00:24:29.099 --> 00:24:31.460
to get a baseline. And you have to know, did

00:24:31.460 --> 00:24:33.339
that building sell based on what it was making

00:24:33.339 --> 00:24:35.420
or what the buyer hoped it could make? So the

00:24:35.420 --> 00:24:39.890
rule is never. The rule is audited financials

00:24:39.890 --> 00:24:43.430
only. A T12, a trailing 12 -month profit and

00:24:43.430 --> 00:24:46.009
loss statement. Don't tell me what it could make.

00:24:46.309 --> 00:24:49.109
Show me the bank deposits. Use the effective

00:24:49.109 --> 00:24:52.170
income for your GRM, not the potential. Unless.

00:24:52.730 --> 00:24:55.769
Unless. Well, unless you're a professional developer

00:24:55.769 --> 00:24:58.089
and your entire business model is buying broken

00:24:58.089 --> 00:25:00.710
buildings and creating that potential. But that's

00:25:00.710 --> 00:25:03.230
a different game. For the average investor, stick

00:25:03.230 --> 00:25:06.430
to reality. Stick to reality. I like that. Which

00:25:06.430 --> 00:25:09.150
leads us to our final and maybe most sobering

00:25:09.150 --> 00:25:12.430
reality check, Section 7, the shortcut critique

00:25:12.430 --> 00:25:15.730
and the DCF model. We've spent a good chunk of

00:25:15.730 --> 00:25:18.009
time talking about how useful GRM can be as a

00:25:18.009 --> 00:25:20.609
quick filter, but our source material takes a

00:25:20.609 --> 00:25:22.470
pretty sharp turn towards the end. It does. It

00:25:22.470 --> 00:25:24.470
basically stops being polite and starts being

00:25:24.470 --> 00:25:27.009
very academic. It calls procedures like GRM and

00:25:27.009 --> 00:25:30.190
cap rate shortcut procedures. That phrase alone

00:25:30.190 --> 00:25:32.650
feels a bit derogatory. It's meant to be. And

00:25:32.650 --> 00:25:34.190
then it drops the hammer. And I'm quoting directly

00:25:34.190 --> 00:25:37.089
here. As causal models of asset value, they are

00:25:37.089 --> 00:25:39.690
at best simplistic and at worst incomplete and

00:25:39.690 --> 00:25:42.109
sometimes misleading. At worst misleading. That

00:25:42.109 --> 00:25:44.730
is the academic way of saying this tool is dangerous

00:25:44.730 --> 00:25:48.670
and can make you lose your shirt. So if GRM is

00:25:48.670 --> 00:25:52.089
the dangerous misleading shortcut, what is the

00:25:52.089 --> 00:25:54.769
correct way? What is the model that the pros

00:25:54.769 --> 00:25:57.450
use that isn't misleading? The source points

00:25:57.450 --> 00:25:59.650
to what's called the multi -period discounted

00:25:59.650 --> 00:26:03.009
cash flow procedure, or DCF. Multi -period discounted

00:26:03.009 --> 00:26:04.670
cash flow. Okay, that sounds like something you

00:26:04.670 --> 00:26:07.269
need a PhD in finance to calculate. Or at least

00:26:07.269 --> 00:26:09.329
a very, very good Excel spreadsheet with a lot

00:26:09.329 --> 00:26:11.589
of tabs. How is it different from GRM? Can you

00:26:11.589 --> 00:26:14.710
use an analogy for me? Sure. GRM is a Polaroid

00:26:14.710 --> 00:26:16.930
snapshot. It's instant. You press the button

00:26:16.930 --> 00:26:20.440
and you get one picture of one moment. In time,

00:26:20.519 --> 00:26:22.799
today's price, today's rent. It's completely

00:26:22.799 --> 00:26:25.420
static. Okay, a snapshot. I get that. DCF is

00:26:25.420 --> 00:26:27.779
a full -length documentary film. The source says

00:26:27.779 --> 00:26:30.019
it looks at the more complete multi -period total

00:26:30.019 --> 00:26:32.640
return perspective. It forces you to project

00:26:32.640 --> 00:26:34.859
the entire movie of this building's financial

00:26:34.859 --> 00:26:37.920
life for the next 5, 10, or even 20 years. So

00:26:37.920 --> 00:26:39.759
it's not just asking, what's the rent today?

00:26:40.019 --> 00:26:42.579
It's asking questions like, what will the rent

00:26:42.579 --> 00:26:44.960
be in year three? What happens when the roof

00:26:44.960 --> 00:26:48.079
inevitably fails in year five? What happens when

00:26:48.079 --> 00:26:50.259
the special property tax abatement expires in

00:26:50.259 --> 00:26:53.630
year eight and taxes double? Exactly. It projects

00:26:53.630 --> 00:26:56.230
all of those future cash flows, both positive

00:26:56.230 --> 00:26:58.569
and negative, and then it discounts them back

00:26:58.569 --> 00:27:00.569
to what that future money is worth in today's

00:27:00.569 --> 00:27:03.329
dollars. Because a dollar in 10 years is worth

00:27:03.329 --> 00:27:06.190
less than a dollar today. That sounds incredibly

00:27:06.190 --> 00:27:09.849
complex. It is, but it's how true fundamental

00:27:09.849 --> 00:27:12.589
value is determined. The source gives a very

00:27:12.589 --> 00:27:15.609
specific high value example. a property valued

00:27:15.609 --> 00:27:20.210
at $18 ,325 ,000. That's a very, very specific

00:27:20.210 --> 00:27:24.569
number. Not $18 million, but $18 ,325 ,000. Now,

00:27:24.589 --> 00:27:27.049
a broker, a salesperson, might look at that deal

00:27:27.049 --> 00:27:29.230
after it closes and say, oh, that property traded

00:27:29.230 --> 00:27:33.430
at a 5 .46 % cap rate, or it traded at a GRM

00:27:33.430 --> 00:27:35.710
of X. And we, the observers on the outside, think,

00:27:35.890 --> 00:27:37.990
okay, so the market value was determined by that

00:27:37.990 --> 00:27:40.809
cap rate. People wanted a 5 .46 % return, so

00:27:40.809 --> 00:27:42.609
they paid that price. But the source says that

00:27:42.609 --> 00:27:45.400
is a fundamental causal. misunderstanding causal

00:27:45.400 --> 00:27:48.440
as in cause and effect right the building isn't

00:27:48.440 --> 00:27:50.500
worth 18 million dollars because the cap rate

00:27:50.500 --> 00:27:53.460
is 5 .46 that's getting the cause and effect

00:27:53.460 --> 00:27:57.039
completely backward so explain the true causality

00:27:57.039 --> 00:27:59.720
what actually happened the investors who bought

00:27:59.720 --> 00:28:02.700
it they did the dcf They built the movie. They

00:28:02.700 --> 00:28:04.700
looked at the 10 year cash flow projections.

00:28:04.839 --> 00:28:07.299
They argued about inflation assumptions and future

00:28:07.299 --> 00:28:09.859
tax rates. They calculated the risk of the neighborhood.

00:28:10.140 --> 00:28:12.839
And that complex, forward looking model spit

00:28:12.839 --> 00:28:15.839
out a number. Based on our projections, this

00:28:15.839 --> 00:28:20.279
building is worth $18 ,325 ,000 to us. So the

00:28:20.279 --> 00:28:24.000
DCF calculation caused the price. Yes. The longer

00:28:24.000 --> 00:28:26.920
term total return perspective, the DCF, caused

00:28:26.920 --> 00:28:29.900
the value. The cap rate and the GRM are just,

00:28:30.019 --> 00:28:32.160
and this is a quote, a reflective representation

00:28:32.160 --> 00:28:35.619
of all that deep underlying work. A reflective

00:28:35.619 --> 00:28:38.019
representation. That is deep. That's a great

00:28:38.019 --> 00:28:40.039
phrase. Think of it like a shadow on a wall.

00:28:40.400 --> 00:28:43.259
The DCF is the object itself, the complex three

00:28:43.259 --> 00:28:45.279
-dimensional reality of the investment with all

00:28:45.279 --> 00:28:48.579
its textures and flaws. The GRM is just the simple

00:28:48.579 --> 00:28:50.900
two -dimensional shadow that object casts on

00:28:50.900 --> 00:28:53.859
the wall. And if I only look at the shadow. You

00:28:53.859 --> 00:28:56.059
might get the general shape. Oh, it's big. Oh,

00:28:56.079 --> 00:28:58.400
it looks tall. But you can't see the texture.

00:28:58.660 --> 00:29:01.440
You can't see the color. And, you know, depending

00:29:01.440 --> 00:29:04.339
on where the light is, a shadow can be very distorted.

00:29:04.619 --> 00:29:07.890
So the GRM is the shadow on the napkin. It's

00:29:07.890 --> 00:29:09.769
useful because I can see it from across the room

00:29:09.769 --> 00:29:12.549
at the diner. But I shouldn't ever buy the building

00:29:12.549 --> 00:29:15.069
based on the shadow alone. Exactly. You use the

00:29:15.069 --> 00:29:16.950
shadow to decide if it's worth walking over to

00:29:16.950 --> 00:29:19.029
the wall to actually look at the object up close.

00:29:19.089 --> 00:29:21.990
I love that. It puts the tool in its proper place.

00:29:22.150 --> 00:29:24.910
It's not the Bible. It's the brochure. The brochure.

00:29:24.970 --> 00:29:27.569
That's a good one. Okay, we have covered a massive

00:29:27.569 --> 00:29:29.809
amount of ground today. From the back of the

00:29:29.809 --> 00:29:33.480
napkin to the... The philosophical nature of

00:29:33.480 --> 00:29:36.319
value shadows. Let's try to bring it all home

00:29:36.319 --> 00:29:38.759
with a quick recap. Sure, let's do it. First,

00:29:39.000 --> 00:29:43.960
gross rent multiplier. The formula is price divided

00:29:43.960 --> 00:29:46.440
by gross annual rent. And remember, that's effective

00:29:46.440 --> 00:29:48.940
gross income. Use the real rent you actually

00:29:48.940 --> 00:29:51.440
collect, not the fantasy rent from the flyer.

00:29:51.539 --> 00:29:54.740
Second, it's a measure of time. It's the years

00:29:54.740 --> 00:29:58.299
to pay back. Lower is generally better, but too

00:29:58.299 --> 00:30:02.160
low can be a sign of danger. Third. Watch out

00:30:02.160 --> 00:30:04.259
for the monthly trap. If you see a number like

00:30:04.259 --> 00:30:07.299
100, just divide by 12 to get the real annual

00:30:07.299 --> 00:30:10.059
multiplier. Fourth, it only works because of

00:30:10.059 --> 00:30:12.660
uniformity. It's fantastic for comparing apples

00:30:12.660 --> 00:30:15.220
to apples, but it fails completely when you're

00:30:15.220 --> 00:30:18.019
comparing brand new apples to old rotten apples.

00:30:18.220 --> 00:30:21.869
And finally, the big one. It is a shortcut. It's

00:30:21.869 --> 00:30:24.730
a reflective representation. It gives you a hint,

00:30:24.829 --> 00:30:27.710
but it does not replace the hard, forward -looking

00:30:27.710 --> 00:30:30.349
work of a discounted cash flow analysis for determining

00:30:30.349 --> 00:30:32.930
true value. So here's my final thought for you,

00:30:32.990 --> 00:30:35.210
the listener. The next time you walk past a for

00:30:35.210 --> 00:30:37.670
-sale sign on an apartment building, or maybe

00:30:37.670 --> 00:30:39.289
the next time you're in an argument with a friend

00:30:39.289 --> 00:30:41.049
about whether real estate in your city is a bubble,

00:30:41.410 --> 00:30:43.589
I want you to do the napkin math. Do the simple

00:30:43.589 --> 00:30:45.789
division in your head. Take the price. Make a

00:30:45.789 --> 00:30:48.490
rough estimate of the annual rent. And get that

00:30:48.490 --> 00:30:51.019
number. Is it a 15? Is it a 40? And if it's a

00:30:51.019 --> 00:30:53.319
40, you have to ask yourself, why is someone

00:30:53.319 --> 00:30:55.819
willing to wait 40 years just to get their initial

00:30:55.819 --> 00:30:59.039
money back before any expenses? What are they

00:30:59.039 --> 00:31:02.099
seeing that I'm not? And if it's a 5, ask yourself

00:31:02.099 --> 00:31:04.660
the opposite question. What is so wrong with

00:31:04.660 --> 00:31:06.619
this building that they are desperate to get

00:31:06.619 --> 00:31:09.559
out so fast? The number isn't the answer. The

00:31:09.559 --> 00:31:11.920
number is the question. That is the perfect place

00:31:11.920 --> 00:31:14.759
to leave it. The GRM isn't the answer key. It's

00:31:14.759 --> 00:31:17.099
the question you ask to start the real conversation.

00:31:18.299 --> 00:31:21.059
thanks for joining us on this deep dive go find

00:31:21.059 --> 00:31:22.940
some shadows and see what's casting them happy

00:31:22.940 --> 00:31:23.279
investing