Consider two properties, the first contains twelve one-bedroom units, and the second consists of six two-bedroom units.  Assume that the two properties have identical potential gross income.  Are the properties really identical in value?

Well, maybe the first property is located just across a municipal border resulting in a higher property tax rate.  With all else being equal, the net operating income, and therefore the value of the property with the higher tax bill will actually be lower.

Whenever gross rents are used to value a property, various property-specific factors are necessarily left out of the equation.  Potential gross income excludes vacancy and bad debt and may also include income that a landlord must actually use to pay for utilities.

Differences in the physical makeup of the units may also lead to differences in the net operating income of two properties.  For example, the building with one-bedroom units may have higher maintenance costs, because it has more appliances and more bathrooms than the building made up of two-bedroom units.  The building with more units may also experience higher advertising and management expenses per dollar of rent as well.

Here is an example of how two properties with identical gross rents can have very different net operating income and appraised values:

                                                           Property 1:             Property 2:               Comments on
                                                           One Bedrooms     Three Bedrooms     Property 1
Number of Units:                                     12                                 6
Annual Rent per Unit:                    $  7,800                    $15,600

Potential Gross Income:               $93,600                    $93,600
Vacancy and Bad Debt:                 $  9,500                     $  4,500                   higher vacancy
Effective Gross Income:                $84,100                    $89,100

Expenses:            
Advertising:                                       $  2,000                    $     800                   more units to rent
Bank Charges:                                 $     100                    $     100
Insurance:                                         $  4,500                    $  4,500
Lawn Care and Landscaping:      $     500                     $     500     
Management Fees:                         $  9,360                    $  9,360
Office Supplies:                                $  1,500                    $     800                   more paperwork and supplies
Property Tax:                                     $15,500                    $13,000                   higher tax rate
Professional Fees:                          $  1,200                    $  1,200
Repairs and Maintenance:             $  7,500                    $  4,500                   more appliances to repair
Utilities:                                              $  2,700                     $     900                   rent includes heat and water
Total Expenses:                               $44,860                     $35,660

Net Operating Income: (NOI)         $39,240                    $53,440

NOI divided by 9% Cap Rate:        $436,000                $593,778     

So, if you’re selling a property and applying a gross rent multiplier leads to a higher value than the conventional method based on NOI, then you might stress that value when talking to potential buyers.  You might also provide an explanation if your historical expenses were out of line or unusual or one-time in nature, so that a buyer or an appraiser can adjust any value based upon NOI upward.

If you’re buying a property, keep in mind that using a gross rent multiplier may fail to account for a situation where the current rents being charged by the seller fall short of market rents.  In this case, there may be room for improvement, and the artificially low rents may be leading to a low valuation when a gross rent multiplier is applied.  In this case, you may adjust potential gross income upward to get a better value.