Gross profit multiplier is a metric used by analysts and appraisers to value commercial real estate. It is easy to calculate and requires very little information, but it does have some limitations. In this article, we take a closer look at what gross profit multiplier means with some examples, including potential gross profit multiplier and effective gross profit multiplier.
What is the total income multiplier?
Gross Income Multiplier (GIM) is defined as the ratio between the selling price or value of the property and the total income from rent and other sources.
The gross income multiplier is a metric used in commercial real estate analysis to compare the income-producing characteristics of properties. It can be calculated using either the property's potential gross income or effective gross income.
Total Income Multiplier Formula
The gross income multiplier formula can be calculated using either the property’s Potential Gross Income (PGI) or the property’s Effective Gross Income (EGI).
The main difference between PGI and EGI is that Potential Gross Income considers all sources of income for a property and makes no deductions, while Effective Gross Income starts with Potential Gross Income and subtracts vacancies and recovery losses.
Because total income multipliers can be calculated in multiple ways, it is important to be clear about how GIM is calculated and to use a consistent methodology when making comparisons.
How to calculate the gross income multiplier
Let's look at some examples of how to calculate total income multipliers. First, we'll look at how to calculate the potential total income multiplier, and then we'll explain how to calculate the effective total income multiplier.
Suppose you want to evaluate the following simple pro forma:
Let's look at how to calculate the gross income multiplier using the sample pro forma figures above.
Potential Total Revenue Multiplier
The Potential Gross Revenue Multiplier uses the Potential Gross Revenue item from the quote. In this case, the Potential Gross Revenue Multiplier is calculated by dividing the sales price of 500,000 by the Potential Gross Revenue of 100,000. This results in a Potential Gross Revenue Multiplier of 5.00.
Effective Total Income Multiplier
Effective gross income is calculated by subtracting vacancies and credit losses from potential gross income.
The effective gross income multiplier uses the effective gross income line item from the pro forma. In this case, the effective gross income multiplier is calculated by dividing the sales price of 500,000 by the effective gross income of 90,000. The result is an effective gross income multiplier of 5.55.
This simple pro forma only considers vacancy and credit losses, but with more complex pro formas, the calculation of gross income can be more nuanced. For example, here is a more detailed commercial real estate pro forma:
In this more detailed pro forma, the gross income multiplier can be calculated using gross income items or effective gross income items. In practice, deductions or additions may be omitted or there may be other variations in the gross income multiplier. The important thing to remember is that you need to be clear about how you calculate the gross income multiplier and use a consistent methodology when making comparisons.
What is a good gross revenue multiplier?
An appropriate Gross Revenue Multiplier will vary depending on how you use it, but generally it is one that meets your requirements. For example, let's say you require the GIM of the property you are acquiring to be close to the market average. If you identify five comparable properties and determine that their average Gross Revenue Multiplier is 7.00, then an appropriate Gross Revenue Multiplier for the property you are considering would be close to that average.
For an appraiser, the appropriate gross receipts multiplier for appraisal purposes is one that is based on comparable properties that have truly similar characteristics.
However, it is important to understand that gross income multipliers do not take into account operating expenses, capital expenditures, property appreciation, or future changes in income. Therefore, a property may have a good gross income multiplier but still be a bad investment. On the other hand, a property may have a bad gross income multiplier based on a group of similar properties, but still be a good investment due to investment strategy or operational advantages.
The bottom line is that there is no silver bullet in investment analysis and the gross profit multiplier should not be used in isolation. Instead, it should be considered in conjunction with other investment metrics where possible, such as cap rates, equity multiples, cash-on-cash returns, IRR, NPV, and the overall strategy and risks associated with the opportunity.
Gross Revenue Multiplier and Cap Rate
The gross capitalization rate is used by real estate appraisers to estimate the market value of a property.
Cap rates can be estimated using a variety of methods, including derivation from similar properties sold or the investment band method. However, gross capitalization rates can also be derived using a gross income multiplier. Let's look at how this works.
In some cases, an appraiser may not be able to directly derive an overall market capitalization ratio because they are unable to meet strict data requirements for comparable properties. If they still have recent reliable transaction data that includes the gross income of the comparable properties, they can instead use this gross income data and the net income ratio to estimate the cap rate.
Net income ratio (NIR) is the ratio of net operating income to effective gross margin. Net income ratio is the complement of the operating expense ratio (OER), since NIR = 1 – OER.
Appraisers can often fairly easily obtain market averages for operating expense ratios and effective gross income multipliers. Using this data, the appraiser can derive the gross capitalization ratio using the following formula:
For example, let's say you identify a similar property that recently sold for 375,000. The potential gross income for this property is 80,000 and the actual gross income is 75,000.
This property has an operating expense ratio of 58.50% while the comparable property has operating expenses of 43,875 and a net operating income of 31,125.
The effective gross income multiplier is 375,000 / 75,000 or 5.00. The net income ratio is 31,125 / 75,000 or 0.415. Therefore, the overall capitalization rate can be calculated from the comparable properties as follows:
0.415 / 5.00 = 8.3%
Once you have completed this process for all comparable properties, you can estimate your overall cap rate by adjusting each of the cap rate metrics derived from the comparable properties.
Total Revenue Multiplier and Total Rent Multiplier
What is the difference between the Gross Revenue Multiplier and the Gross Rent Multiplier? The Gross Revenue Multiplier takes into account the rental income and all other income sources of the property, whereas the Gross Rent Multiplier only takes into account the gross rental income of the property and does not include ancillary income sources.
Let's look at an example of the difference between gross revenue multiplier and gross rent multiplier. Consider the following pro forma:
In this case, the Gross Rent Multiplier only takes into account the potential rental income item of 100,000. If the selling price of this property is 2,637,000, then the Gross Rent Multiplier would be 2,637,000 / 100,000 or 26.37.
In contrast, the total income multiplier takes into account all income sources, not just rental income. In this case, the total income multiplier is calculated as 2,637,000 / 146,000, or 18.06.
There can be variability in how these multipliers are calculated, so it is important to be clear about how they are calculated and to use a consistent methodology when making comparisons.
Limits on the Total Income Multiplier
The Gross Income Multiplier is a useful ratio to have in your toolbox when valuing commercial real estate. Its strength is that it relies on data that is more easily obtained, as it only requires the property's gross income. However, because the GIM only uses high-level income data, it also means that it is not as accurate or reliable as other metrics that take into account property expense data.
If net operating income data is not available, market averages for gross income and operating expenses can be used in conjunction. This allows you to estimate market value using only market averages for gross income and operating expense ratios. However, it is not uncommon for two similar properties to have roughly the same net operating income but vastly different gross incomes. This can be due to differences in the age of the properties, mismanagement, etc. These are all factors not taken into account by the gross income multiplier.
Conclusion
In this article, we defined gross profit multiplier (GIM), reviewed the formula for gross profit multiplier and how to calculate it, what a good gross profit multiplier is, and compared GIM to gross rent multipliers and cap rates. In explaining capitalization rates, we discussed one way that an effective gross profit multiplier can be used to estimate a cap rate. Finally, we discussed limitations of gross profit multipliers that you should be aware of.