Market Rents, Below-Market Leases, and a Broker's GRM
The subject is a four-unit apartment building: two 2-bedroom/1-bath units and two 1-bedroom/1-bath units. Current rents are $850, $850, $700, and $700 per month. Market rents are $950, $950, $775, and $775. Vacancy and collection loss is 5% of potential gross income; operating expenses run 38% of effective gross income. Two fourplex sales closed in the past year: one at $420,000 with actual rents of $3,000 per month; the other at $455,000 with rents averaging $3,450 per month. The buyer of the subject would likely raise rents to market over 12 months, but two tenants have nine months left on leases. The local cap rate for similar fourplexes is 6.0%. A broker tells you to 'just use an 11.5 GRM because that is what the market uses.'
1. Calculate PGI, EGI, NOI, and value by direct capitalization. Should you use actual or market rents?
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Market potential gross income = (2 × $950 + 2 × $775) × 12 = $3,450 × 12 = $41,400. Effective gross income = $41,400 × 0.95 = $39,330. Operating expenses = $39,330 × 0.38 = $14,945. Net operating income = $39,330 − $14,945 = $24,385. Value at a 6.0% cap rate = $24,385 / 0.06 = $406,417. Use market rent for market value because a typical buyer would raise rents, but do not ignore the leases. The two below-market leases with nine months remaining are an encumbrance. If the assignment is to value the property subject to those leases, use contract rent for the remaining term and market rent thereafter, preferably with a discounted cash flow. At minimum, show both scenarios: actual rents produce PGI of $37,200, EGI of $35,340, expenses of $13,429, NOI of $21,911, and value of about $365,183 at 6.0%. The difference is material, so the lease terms must be disclosed and reconciled.
2. Evaluate the broker's GRM suggestion. What is the implied GRM from your direct-cap value, and what data would you verify before using a GRM?
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The broker's 11.5 GRM applied to market PGI gives 11.5 × $41,400 = $476,100, which is much higher than the direct-cap indication of about $406,400. The implied GRM from the direct-cap value is $406,417 / $41,400 = 9.82. A GRM is only reliable when the subject and comparables have similar expense ratios, vacancy, unit mix, rent levels, and condition. The first comparable at $420,000 with $36,000 annual actual rent has a GRM of 11.67; the second at $455,000 with $41,400 has a GRM of 10.99. Those GRMs may reflect below-market rents, different expenses, or superior condition. Verify each comparable's actual rents, lease terms, vacancy, operating expenses, unit mix, and capital reserves. Also check the implied cap rate: with a 38% expense ratio and 5% vacancy, NOI/PGI = 0.95 × 0.62 = 0.589; an 11.5 GRM implies a 5.12% cap rate, below the 6.0% market cap rate, so the broker's GRM is not supported.
3. How should the below-market leases be handled in the report?
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Disclose each lease's rent, expiration, options, and any concessions. Explain whether the value opinion is market value subject to the existing leases or market value assuming market rents at stabilized occupancy. If the leases are below market, a buyer receives lower cash flow until they expire; that affects value. Use contract rent for the remaining lease term and market rent after expiration, or use a discounted cash flow that reflects the rollover. If you use market rent for the entire year, state that this assumes the leases are not an impediment and explain why; that may be appropriate only for a stabilized market-value opinion, not for an as-is investment value. Reconcile the contract-rent and market-rent indications and explain the weight given to each. Do not simply adopt the higher market-rent value without disclosing the lease encumbrance.