5 Ways To Value A Real Estate Rental Property
There are five primary methods for evaluating the potential value of a rental property.
Separately, each method gives you a snapshot. But combine some of these methods together and you’ll have enough information to make a well-informed decision.
Individually, though, each one of these techniques will provide you with a lot of useful data and will allow you to weed out properties from consideration quickly so that you don’t end up spending more time than necessary to make your decision.
1. The Sales Comparison (SCA) Approach
The method most commonly used by appraisers and real estate agents, the sales comparison approach (SCA) entails comparing similar homes that have been sold or rented in the area over a particular time frame. Most investors will want the time period to be significant enough that they can identify trends.
To use the SCA method, you want to use specifics that your property has in common with others. This may include the number of bedrooms and bathrooms, the presence of garages, pools, decks, fireplaces, etc. The price per square foot is a commonly used metric. So, if you have a 2,000 square-foot townhouse that’s renting at $1 per square foot, then you can assume a similar income if other rental units in the area are fetching that much.
Given the broad nature of the SCA, it’s only meant to provide a ballpark estimate. You can only use it to compare properties that have a significant amount in common. A comparison between two properties of a similar square footage, for example, won’t be useful if one of the properties has a lot of qualities that the other lacks.
The estimate will be inaccurate, for example, if both properties are 2,000 square feet, but one has a swimming pool, two fireplaces, and a garage, and the other doesn’t.
2. The Capital Asset Pricing Model
The capital asset pricing model (CAPM), is a more accurate means of evaluating potential rental income. CAPM incorporates risk and opportunity cost. It looks at return on investment (ROI) derived from your income stream and juxtaposes it to investments that have no risk, like United States Treasury bonds or other means of investing in real estate, like real estate investment trusts (REITs).
Basically, if your ROI on a risk-free or sure-fire investment is greater than what you may potentially make off your rental property, then that rental property is an investment you shouldn’t make. What makes CAPM useful, as you can see, is that it takes into account the risks of investing in rental properties.
CAPM is a more granular model because it actually takes into account real differences between properties. Location and property age, for example, are very important factors. Older properties mean higher maintenance. This may be because major renovations are required or because, given the age of the materials, the costs are higher since the materials may be more scarce or require greater specialization to provide upkeep. Similarly, there’s a very real difference between property in a high crime area and a property in a gated community.
By taking these different factors into consideration, CAPM will help you determine if the risk is really worth it.
3. The Income Approach
Frequently used for commercial real estate investing, the income approach looks at the potential income stream of your rental property relative to initial investment. This approach uses the annual capitalization rate for your investment (cap rate). The cap rate is your projected net operating income (NOI) divided by the current value of your asset. Your NOI is your gross income minus operating costs (gross income being how much you make before taxes).
How to Calculate the Income Approach
If, for example, your office building cost $120,000 to buy and your expected NOI is $1,200, then the way you’d calculate your cap rate is as follows:
14,400 ($1,200 x 12 months) ÷ $120,000 = 0.12 or 12% (cap rate)
From this formula, you may think that a higher cap rate means your property either costs less to begin with or your projected income is higher. But this formula provides a very simplified calculation because there may be interest rates on a mortgage to consider or your rental may fluctuate over a few years.
If you looked at the cap rate for only a year in which your rental income was high it would give you an inaccurate picture of your property’s worth. In fact, a lower cap rate may make for an even better investment because you can increase rent over time while many of your expenses remain unchanged (this may be the case if, for example, the cost of your property was low and you have a low-interest mortgage).
Another way that knowing the cap rate may be useful is when you’re comparing several property values. Let’s say you have a property that’s $1,000,000 and the NOI was $150,000, making the cap rate 15%. If you look at other properties in the neighborhood sold for the same amount but they have an NOI of $100,000 then the cap rate would be 10%. In this case, if you know the property’s value and the cap rate then it’s fair to think that the NOI is less due to higher operating expenses or a lower income stream.
4. Gross Rent Multiplier Approach
This is a straightforward method: you just approximate the value of your rental property using the amount of rent you can collect every year. Keep in mind, this takes taxes, insurance, utilities, vacancies, and all other expenses for granted. You just take the value of your property and divide it by your gross rental income for the year. The resulting figure is known as the gross rent multiplier (GRM).
How to Calculate the Gross Rent Multiplier
So, let’s say you bought your property for $500,000 and your projected gross rental income is $90,000. The math will look like this $500,000 ÷ $90,000 = 5.56. Using this GRM, you can get a ballpark estimate of how long it would take you to pay off your property. Just remember that this calculation is made using the gross rental income rather than the NOI. Like the cap rate, the GRM should only be one tool in your evaluative arsenal.
The GRM can be used to calculate a property’s fair market value. The gross annual rental income multiplied by GRM gives you the property price. 5.56 X $90,000 = $500,400. Roughly the figure we started with. You can also use the GRM to figure out the gross rent. $500,000 ÷ 5.56 = $89, 928 (again, roughly the number we started with).
A lower GRM may suggest that it takes less time to pay off a property, but you should keep in mind that an older property may require higher maintenance costs. This may because the property has reached the age where it needs significant one-time expenses, like a roof or HVAC replacement.
For this reason, a GRM grading system can be useful.
Low GRM = An older property that may require a lot of major repairs.
Average GRM = A property built within the last 10 or 20 years that needs modernization, like energy-efficient windows, new appliances, and possibly a new roof.
Above Average GRM = A property that’s 10 years-old max that requires moderate maintenance to make it ready for the market.
High GRM = A brand new property that requires little work because everything is new.
How good the GRM also varies based on the location. A GRM of 12 for Atlanta may be good because that’s a short amount of time to pay off a property in a market like Atlanta’s. But in a town like Lufkin, Texas where the average GRM is 7, a GRM of 12 is too high, indicating that either the property cost too much or the gross annual income is too low.
5. The Cost Approach
The cost approach puts forth the argument that an asset is only worth what it can reasonably be used for. The cost approach calculation is made by adding the cost of land to the cost of construction, minus depreciation, which is a tax deduction you take every year based on the cost of your property and any improvements (minus the cost of land). The estimate is most useful when the property is new.
Instead of looking at what similar homes in the area are fetching or how much income an asset may generate, this method ascribes property its value based on how much it would cost if the building were to be built entirely from scratch today. The idea is that it doesn’t make sense to buy a property for more than what it would cost to build anew.
How to Implement the Cost Approach
There are two routes to implementing this method: considering the cost given the original materials and considering the cost given modern materials, contemporary construction techniques, and an updated design. Once that’s done you take the cost of the new building, subtract depreciation, and add the cost of land to get the value of your property.
You’d use the cost approach to determine the value of exclusive-use properties that generate little to no income or usually aren’t for sale, which renders income and other considerations moot. So, you’d use it when looking at libraries, schools, or churches, for example.
The cost approach is also used for new construction. That’s because the market value and potential income stream are contingent upon the quality of the project and when it’s completed. Construction projects are often reappraised throughout the building process to facilitate the release of the funds needed for the next stage of construction.
The cost approach is also sometimes used to value commercial properties such as offices, stores, and hotels. This is done when the design, construction, functionality, or the quality of materials require individual attention.
The Bottom Line on Evaluating a Rental Property’s Value
Using a combination of these different methods, you can calculate the value of your property and determine whether it’s worth your time as an investment.
It’s important to remember that no one technique will give you a robust picture, so it’s best to use these methods in combination with one another.
Additionally, you’ll want to look at these metrics over time and in comparison with nearby properties to get the most accurate picture.