Wednesday, April 15, 2009

Correlation between Neighborhood Characteristics and GRM

In one of the seminars I attended, I met a gentleman in his mid fifties. Despite the worldwide financial troubles, he saw a lot of opportunities in the real estate and wanted to start putting his money into real estate. He asked me if I can find him a property which produces annual rent 12%-15% of purchase price. That means GRM of 6.7-8.3.

GRM or Gross Rent Multiplier is a simple way of comparing investment properties by dividing the purchase price by gross annual rent before vacancy and expenses.

                                                                      Purchase Price
Gross Rent Multiplier (GRM) = -----------------------------------------------------------------------
                                              Gross Annual Rent before Vacancy & Expenses

Again, GRM is just a rough estimate to compare properties. For accurate financial analysis, all factors such as vacancy, repairs to bring property ready for rent, taxes, insurance and property management fees have to be included.

While it is not impossible to find GRM of 6.7-8.3, based on my experience, you will find those properties located in depressed neighborhood. I call them “junk real estate”.

Let’s examine neighborhood characteristics based on median household income, poverty level, vacancy, ratio of renter occupied to owner occupied and crime rate. Those data can be found from US Census Bureau and local police department. From scale 1 to 5, I give 1 to neighborhood with the lowest median household income, highest poverty level, vacancy, ratio of renter occupied to owner occupied and crime, while I give 5 to neighborhood with the highest median household income, lowest poverty level, vacancy, ratio of renter occupied to owner occupied and crime.

As a case study, we’ll take a look at 5 single family homes with 3 bedrooms located in Oakland.

Neighborhood characteristics12345
NeighborhoodEast Oakland Lake MerrittOakland HillsOakland HillsPiedmont Pines
Beds/Baths/Sq ft3 /1 /12483 /1.5 /14943 /1.5 /15083 /1.5 /15423 /2 /1716 ZESTIMATE$221,500$367,000$466,000$587,500$709,500
Monthly rent$1,600$1,975$2,295$2,500$2,795

Compare the house in east Oakland and Lake Merritt. Lake Merritt house is 66% more expensive than east Oakland house, but the rent is only more expensive by 23%. Compare any other 2 houses above, you will find, the percentage increment of rent tends to be less than the percentage increment of housing values. It shows you a tendency of higher GRM as the neighborhood characteristics improve, because the price goes up faster than the rent. While this tendency generally holds true regardless of the location (eg: Phoenix instead of Oakland), this analysis is only a general observation, and not an exact science. Instead of fixed value of GRM, you will find a range, and it could be possible that two neighborhood characteristics have GRM range overlap to each other.

House Value and Monthly Rent
I personally stay away from investing in depressed neighborhood and advise the same thing to my clients, but I know other investors who mainly invest in low end housing. It really depends on your objective, risk tolerance and experience. Why people invest in low end housing? Lower GRM usually means higher cash flow. They get more steady income from the cash flow regardless of the appreciation and the up and down of the housing market (please read “Nice Cash Flow or Great Appreciation?”).

Few years ago, one investor bought multi unit property in depressed downtown Los Angeles. He worked with police department, evicted drug dealers, and promoted education in the community. As a result, the quality of the neighborhood gradually improved. As the quality of the neighborhood improved, so did the building value.

If investing in low end housing is appealing to you, three properties are available, two of them currently offered at $49K, and the third one offered at $59K. You won’t be able to find these houses in the MLS.

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