With increasing regularity, I am asked a variation of the question, "Why should I buy multi-family buildings in Boulder County at a 9 or 10 GRM when I can still buy a building in (Anycity), (Anystate) at a 6 or 7 GRM?"

First, let's make sure that we are all on the same wavelength. GRM stands for Gross Rent Multiplier. It is calculated by dividing the Potential Gross Income (PGI: the maximum annual income before deductions for vacancy, utilities, taxes, management, etc.) by the value or purchase price. The commonly practiced theory is this: if an investor is trying to determine which building to purchase and they both have an SGI of $100,000, isn't it wiser to buy the building that has a 7 GRM (It can be purchased for $700,000.) rather than the building that has a GRM or, say, 10 that can be purchased for $1,000,000? After all, why pay $1,000,000 for a $100,000 income when you can acquire the same income for $700,000?

It's a good question, one that strikes directly at the heart of investment analysis and theory. Unfortunately, it cannot be answered in a coherent sentence or even in a cleverly worded paragraph.

Before the more lengthy discussion that follows, let me just say that the reason to invest is not to buy property (or cash flows) at the lowest price. The objective is wealth accumulation or ending up with the most money in the shortest period of time with the least risk.

My father taught me the same lesson that I bet your dad taught you, "Never buy a horse without checking its teeth." A horse might look perfectly good from the exterior but have severe internal problems. With horses, an experienced (and often not so experienced) eye has the opportunity to determine the general state of health of the animal by looking at its teeth. Rotten teeth are a barometer of rotten health. This is equally true of an investment property.

What about other external factors such as location, economic dynamics, construction, general condition, the seller's situation, demographics, obsolescence?

What about internal factors such as vacancy rates, other income, credit losses, all the expenses, net operating income (NOI), mortgage rates, depreciation, etc. These internal factors are the property's "teeth" and will help you determine the overall health and real value of your investment "horse".

We are about to get into some detail. In doing so, the danger is that we will get bogged down in minutia and lose sight of the critical point that it is far less important what you pay for a property than the extent to which you profit from its ownership. Which seems more reasonable (and valuable) to you: making your investment decision based upon a ratio of income to value, or making your decision based upon how much more money you will have in your pocket at the end of the investment than you had in the beginning? The former is a math question. The latter is an accumulation of wealth question.

If the accumulation of wealth is your investment intention then you must answer three questions prior to making your investment decision: "How much in?" "How much out?" "When?"

First, "How much am I going to need to invest in this property?" This is not a simple matter of the down payment. Certainly, the amount "in" includes your down payment and associated closing costs (your initial investment), but it also includes the money that you will need to invest to complete your investment plan. For instance, how much money are you going to need in the first year to repair the roof, put on new counter tops, paint the trim, re-carpet 20% of the units and promote the units to the local manufacturing company? How much money will you need in year two to re-seal the parking lot, install an automatic sprinkler system and re-carpet 20% of the apartments? How much money will you need in year three to buy new refrigerators and stoves for 25% of the units and re-carpet 20%?

Each of these expenditures needs to be determined and then discounted to the date of purchase so that you will know how much money you will need to carry out your investment plan. The point in answering the question "How much in?" is to fully grasp what the investment may require financially. This is the amount against which your returns must be measured.

Determining "How much out?" is the process of assessing the annual cash flows and the net proceeds upon sale. In combination, these sums are applied against the initial investment to ascertain returns.

The annual cash flows, usually measured before tax, are calculated as follows:

The formula for ascertaining the before tax net proceeds upon sale is simply the Sale Value less the Costs of Sale and Loan Repayment.

Investment analysis then considers the net sale proceeds, the total annual cash flows during the ownership period and the investment earnings on these cash flows (all being discounted back to the date of purchase so as to account for the investment term) as the Internal Rate of Return or IRR.

The answer to the third question, "When?" is vital to the development of an IRR because of the phenomenon usually referred to as the "time value of money" and the resultant discounting process used to assess it. The problem in investments with a term longer than one year is that the value of a dollar today is greater than the value of a dollar received next year and much greater than the value of a dollar received ten years hence. This is true because a dollar in hand today may be invested and a year later be worth $1.05, $1.20 or more.

In the early days of my investment career the proper analysis of an investment was such a laborious, time consuming process that people simply didn't do it... investors relied on "gut feel" and "down and dirty" calculations such as the GRM.

Today, however, computers and electronic calculators have made possible the thorough and relatively quick analysis of investment properties. Surprisingly, many investors continue to rely on superficial and primitive methods of analysis.

There is far more to profitable investing than striving to buy low and hoping to sell high. Frankly, it is ludicrous to acquire a building in Phoenix or Toledo or Shreveport simply because, "The GRM was half what I can get in Boulder, and 60% of Longmont or Westminster!"

The GRM is simply not the point. Instead, focus on how to make the most money (more is better than less) in the least time (sooner is better than later) with the least risk (certain is better than maybe).

So, my answer to the original Why should I buy multi-family buildings in Boulder Country at a 9 or 10 GRM when I can still buy a building in (Anycity), (Anystate) at a 6 or 7 GRM?" is that it is both impossible and imprudent to make a valid decision based on this information.

Buying or selling investment properties without a financial analysis is like , buying a used car based on kicking the tires, slamming the door and driving it around the block. - MH