James H. Boykin, MAI, SRA, PhD, and Margaret T. Gray
The Relevance and
Application of the Gross
Income Multiplier
The income multiplier valuation technique is both sound and reliable when properly
applied. This article explains the relative merits of this method and distinguishes between the derivations and uses of different income multipliers.
ust as a capitalization rate is used to
J
express a relationship between net oper-
ating income (NOI) and value, a gross income multiplier (GIM) is used to express
a relationship between gross income and
value. Perhaps because of their simplicity, multipliers have received little academic attention. This article provides a
review of the treatment of the GIM in real
property appraisal literature; its popularity and its reliability as an indicator of
market value are addressed as well. Further, the GIM is related here to the traditional price/earnings ratio that is frequently used in stock valuation. A
distinction is made between gross rent
multipliers (GRMs) and GIMs as well as
between potential gross income multipliers (PGIMs) and effective gross income
multipliers (EGIMs). The relative merits
of the use of the GIM as a valuation tool
are discussed as well.
HISTORICAL PERSPECTIVE OF THE
GROSS INCOME MULTIPLIER (GIM)
The concept of the GIM is neither new nor
li mited 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
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 i s 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.
203
Perhaps one
of the most
compelling
arguments for
the use of the
GIM is that
it is a marketderived fact
that does not
rely on
personal
judgment or
subjective
conclusions.
rental should be multiplied by a specified
number of years.'
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.i 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 ac-
tually being received, but those which are
recognized as the fair rents for similar
space."'
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 (see Figure 2).
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 market-
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.
6. Ibid.
7. Ibid.
20 4
The Appraisal Journal, April 1994
FIGURE 1
GRM versus Sale Price:
Single-Family Residential Property
Richmond, Virginia, Metropolitan Area (1991/1992)
c0
73
83
93
103
113
123
133
143
1 53
1 63
Sale Price (in thousands of dollars)
place 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.' 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 de-
8. Richard U. Ratcliff, "Don't Underrate the Gross Income Multiplier," The Appraisal Journal (April 1971): 264.
9. Ibid.
Boykin/Gray:
Relevance and Application of the Gross Income Multiplier
205
FIGURE 2 Building Operating Expense Ratio:
All Classes of Properties Except Single-Family Residential
Richmond, Virginia, Metropolitan Area (1991/1992)
12
10
8
0
C
6
4
2
0
0
5
10
15
20
25
30
35
40
45
Building Operating Expense Ratio (in percentages)
rived 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 dose 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
50
206
The Appraisal Journal, April 1994
60
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.""
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.
10. Roger E. Cannaday, "A Systematic Framework for Alternative Methods of the Income Approach,"
Appraiser (May 1991): 62.
11. Ibid.
55
The Real Estate
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
less vacancy and collection loss
Effective gross income
Sale price $2,500,000
PGIM $2,500,000/$500,000 = 5
EGIM $2,500,000/$475,000 = 5.3
$500,000
$ 25,000
$475,000
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 in-
terpreted, 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.
Advantages
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.""
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."
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.""
6. Operating expense data typically
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.
Boykin/Gray: Relevance and Application of the Gross Income Multiplier
207
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.
Disadvantages
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 NOl, 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
20 8
The Appraisal Journal, April 1994
comparable properties. By ignoring remaining economic life, a
practitioner can assign equal values to a new property and a 50year-old property, assuming they
generate equal incomes.
CONCLUSION
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.