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How to Evaluate Rental Property Value

How to Evaluate Rental Property Value

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Rental property is valued differently by real estate investors than it is by regular homeowners. Outside of providing better living for prospective tenants, investors buy a rental property to produce cash flow and build equity from forced and market appreciation.

Investing in rental property is a terrific strategy to diversify your income-generating assets and create wealth for future generations. However, evaluating rental properties before engaging in any real estate transaction is crucial.

In this article, we’ll cover all the things you need to assist you in making the best possible investment choice and steering clear of deals that simply don’t work.

Key Takeaways

  • A real estate investor can assess the future market value of a rental property using one of five main approaches.
  • Including the sales approach, income approach, gross rent multiplier approach, capital asset pricing model approach, and the cost approach.

How to Evaluate Rental Property Value

Real estate investors frequently value a rental property using several methods, and then the results are compared.

A real estate investor can assess the future market value of a rental property using one of five main approaches.

Each approach provides you with a different view. However, combining a few approaches will give you enough knowledge to make an educated decision.

1.) Sales Comparison

sold property sign

Using recent comparable sales, appraisers and real estate brokers use the sales comparison approach to estimate the fair value of a property.

The sales comparison technique, also known as an SCA, comps, or the price-per-square-foot approach, contrasts equivalent residences recently sold during a specific period.

Ideally, similar properties have sold recently—within the last thirty days or so, depending on the local real estate market’s activity. Homes that closely resemble the property appraised in age, square footage, number of bedrooms and baths, and lot size are the best comparable sales.

Therefore, if your two thousand-square-foot condominium is renting for $1 per square foot and other rental properties in the neighborhood are renting for that much, you might estimate a similar income.

The SCA is only supposed to provide a general idea because it is broad. It can only be used to assess how your investment property stacks up against similar properties. If one of the homes has many characteristics that the other doesn’t, for instance, comparing two properties with similar square footage won’t be helpful.

2.) Income Approach

The future net operating income generated is one of the key reasons an investor buys a rental property. Therefore, along with other valuation techniques, it may make excellent financial sense to consider current and prospective income when assessing a rental property.

The income approach, also known as the income cap rate technique, is most frequently applied to commercial real estate. You’ll arrive at the property’s net operating income by deducting running costs from rental income (NOI).

A property’s total rental income includes the standard monthly rent and any additional income items such as pet rent, water income, and private parking income, to name a few. Operating expenditures include charges for things like property management and leasing, upkeep and renovations, property taxes, and insurance.

However, operating expenses do not cover depreciation, like large-ticket CAPEX items like a new roof, a new HVAC system, or even your mortgage payment.

Find the net operating income, then divide it by the value of the property or sales price to get the capitalization rate (cap rate):

Cap Rate = NOI / Property Value

For instance, if you we’re looking to purchase a property that was being marketed for $142,857, you would calculate your capitalization rate as follows:

$10,000 divided by $142,857= 0.07 or a 7% cap rate

And, if you didn’t know what price the seller was asking for a property, but you knew that the property brought in $10,000 in annual NOI, and the local market cap rate was 7%, how would you determine it’s value based on the cap rate approach?

$10,000 divided by 0.07= $142,857

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3.) Gross Rent Multiplier Approach

A rental property’s worth is determined by the GRM, which compares the income to the property’s price. This valuation method can be a helpful tool when rentals fluctuate quickly, as they are in many markets today.

Additionally, the GRM methodology is quick and straightforward to utilize. The only information an investor needs to calculate GRM is the gross rent and price of the real estate rental property.

Moreover, division is the only mathematical function required:

GRM = Price of the Real Estate / Gross Annual Rental Income

For instance, the GRM would be calculated as follows if a single-family rental property is up for sale with a $160,000 list price and a $15,000 yearly gross rental income.

Property price of $160,000 / gross rental revenue of $15,000 is 10.66

Investors can estimate how long it would take to pay off a rental property using the gross cash flow created using the GRM technique of valuing rental property.

The property would be paid in just under eleven years in the case above. The gross rent multiplier approach doesn’t consider the vacancy rate, upkeep and repairs, property management, property taxes, and insurance.

Even though a rental property could have a lower GRM and hence appear to be of higher value to an investor, it might also need more frequent upkeep or costly capital improvements, such as a new roof or HVAC system.

4.) The Capital Asset Pricing Model

A more comprehensive method for valuation is the capital asset pricing model (CAPM). Opportunity cost and risk are covered in the CAPM as they relate to real estate investing.

This model examines the potential return on investment (ROI) generated by rental income and contrasts it with other risk-free investments like US Treasury bonds or alternate real estate investment strategies like real estate investment trusts (REITs)

In other words, taking on the risk of rental property doesn’t make business sense if the projected return on a risk-free or assured investment exceeds the possible ROI from rental revenue. The CAPM considers the risks associated with renting out real estate when calculating risk.

5.) The Cost Approach

calculator with cost on it

The cost approach says that an asset is only valuable for what it can be utilized reasonably. Depreciation, a tax deduction you take each year based on the price of your property and any renovations, is subtracted from the construction costs in the cost approach estimate (less the cost of land). When the property is brand-new, the estimate is most beneficial.

This method assigns property value mainly on what it would cost to buy the building today if it were to be entirely constructed from scratch rather than considering what similar property in the area is selling for or an asset’s rental value. The argument is that it doesn’t make sense to pay more to purchase a property than it would be to build ground up.

With the different ways of evaluating rental property value covered, let’s understand another vital term in rental real estate valuation: the 2% rule.

What is the 2% Rule in Real Estate?

According to the rule, the rent should equal 2% of the cost of the property. According to that formula, the rent should be $3000 per month for a $150,000 property.

Let’s now look at how you can value investment property when you’re just starting.

How to Value Investment Property When You're Just Starting Out

Local market research is crucial to ascertain the kind of tenants the property would draw. Knowing how to create and market a good rental product in a given market and have enough potential renters is essential. Only when the property rents for a reasonable price and draws in excellent tenants can you anticipate a good and consistent income flow.

When determining how to assess the rental property, location is crucial—being located in an area with good natural traffic is always a plus. Finding quality tenants will be difficult if the property is in an undesirable area with limited natural traffic. When assessing a rental property, consider both the property and the neighborhood.

Also, carefully examining the numbers before you make a real estate investment is a must. Make sure you’re getting a good return on your investment by performing calculations such as the Gross Rent Multiplier, the Income Approach, and others.

Frequently Asked Questions about Valuing Rental Properties

When evaluating properties, appraisers and real estate brokers often employ the sales comparison or income approach. The sales comparison method compares properties that have recently sold or been rented in the area.

Divide the NOI by the market cap rate to estimate the property’s value in the current market. For instance, the property value would be about $6.25 million if the NOI was $500,000 and the local market cap rate was 8%.

How Do You Calculate The Value Of A Rental Property? - Conclusion

You can estimate the value of your property and decide if it’s worthwhile to invest in it by combining the various valuation approaches covered in this article.

It’s crucial to remember that no single approach can provide you with a reliable picture, making it ideal to combine different valuation methods. To get the most realistic picture, you should examine these indicators over more considerable time periods.

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