Depending on the context, the concept of an income multiplier can mean two completely different things. In the world of macroeconomics, the income multiplier effect refers to the fact that money can be re-spent and that a dollar can actually generate more than a dollar of economic activity. In investment real estate, income multipliers are valuation tools.
Economics and Income Multipliers
The concept of the income multiplier is one of the underpinning principles of Keynesian economics. It refers to the theory that a dollar spent turns into more money. For instance, if you pay a worker $50,000, he will spend that money at a variety of places. Those places will then re-spend that money on inventory, utilities and more workers. Those workers will then spend their paychecks, and on and on. One rule of thumb is that a dollar spent in the economy can generate six dollars worth of economic activity.
Income Multiplier Problems
Economic multipliers are rarely as high as they seem, unless you look at the economy on a global scale. For example, if you got a $500 tax rebate and used it to buy a television set, very little of that money would stay in the local economy. Most of it would be sent by the store to the TV's foreign manufacturer. Some of the profits would be sent to the store's headquarters, which, if it's a national company, are probably not located in your home state. Another part of the profit would go to the store's vendors, which are also located all over the place. Finally, a little bit would go to the local employees who would then spend the money locally.
Gross Income Multipliers
Gross rent multipliers or gross income multipliers are also used as a valuation tool in investment real estate. Usually used for small apartment buildings and single-family residences, they're easier to calculate than more advanced models like capitalization rates or internal rates of return. For instance, if houses in a a neighborhood sell at a gross income multiplier of 11, and a house rents for $1,200 per month or $14,400 per year, it should be worth $158,400.
Drawbacks of Multipliers
Multipliers are useful ways to compare prices relative to gross incomes, but they leave two important metrics out. A multiplier only looks at income and ignores operating expenses. It also doesn't take any potential for growth or upside into account. Based on their gross rent multipliers, two small apartment buildings might have the same value, even though one has $55,000 in expenses, and the other costs $75,000 per year to run because it has old, outdated systems that waste energy and need constant maintenance.
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