There are several questions investors ask must themselves when it comes to investing their hard-earned money. How much will the investment return? What does it cost? But more importantly, investors should be concerned with its value. This is especially true when you consider purchasing an investment property.
Income from investment-related property is at a historical high. Rents offer an increasing source of revenue, and it's a steady way to make money. But before getting into the real estate rental game, how does one go about making evaluations?
Read on to find out some of the most common ways to value high-level rental property.
- Determining the cost of and the return on an investment property are just as important as figuring out its value.
- Investors can use the sales comparison approach, the capital asset pricing model, the income approach, and the cost approach to determine property values.
- There isn't a one-size-fits-all solution, so a combination of these factors may need to be applied.
1. The Sales Comparison Approach
The sales comparison approach (SCA) is one of the most recognizable forms of valuing residential real estate. It is the method most widely used by appraisers and real estate agents when they evaluate properties.
This approach is simply a comparison of similar homes that have sold or rented locally over a given time period. Most investors will want to see an SCA over a significant time frame to glean any potentially emerging trends.
The SCA relies on attributes or features to assign a relative price value. These values may be based on certain characteristics such as the number of bedrooms and bathrooms, garages and/or driveways, pools, decks, fireplaces—anything that makes a property unique and noteworthy.
Price per square foot is a common and easy-to-understand metric all investors can use to determine where their property should be valued. In other words, if a 2,000-square-foot townhouse is renting for $1/square foot, investors can reasonably expect income in that ballpark, provided comparable townhouses in the area are going for that, too.
Example of Sales Comparison Approach
Keep in mind that SCA is somewhat generic—that is, every home has a uniqueness that isn't always quantifiable. Buyers and sellers have unique tastes and differences. The SCA is meant to be a baseline or reasonable opinion, and not a perfect predictor or valuation tool for real estate. It's also a method that should be used to compare to relatively similar homes.
So it doesn't work if you're going to value the property you're interested in, which is 2,000 square feet with a garage, swimming pool, six bedrooms, and five full bathrooms with another property that has half the number of bedrooms, no pool and is only 1,200 square feet.
It is also important for investors to use a certified appraiser or real estate agent when requesting a comparative market analysis. This mitigates the risk of fraudulent appraisals, which became widespread during the 2007 real estate crisis.
2. The Capital Asset Pricing Model
The capital asset pricing model (CAPM) is a more comprehensive valuation tool. The CAPM introduces the concepts of risk and opportunity cost as it applies to real estate investing.
This model looks at the potential return on investment (ROI) derived from rental income and compares it to other investments that have no risk, such as United States Treasury bonds or alternative forms of investing in real estate, such as real estate investment trusts (REITs).
In a nutshell, if the expected return on a risk-free or guaranteed investment exceeds potential ROI from rental income, it simply doesn't make financial sense to take the risk of rental property. With respect to risk, the CAPM considers the inherent risks to rent real property.
For example, all rental properties are not the same. Location and property age are key considerations. Renting older property means landlords will likely incur higher maintenance expenses.
Property for rent in a high-crime area will likely require more safety precautions than a rental in a gated community.
This model suggests factoring in these risks before considering your investment or when establishing a rental pricing structure. CAPM helps you determine what return you deserve for putting your money at risk.
3. The Income Approach
The income approach is used frequently with commercial real estate investing because it examines potential rental income on a property relative to the initial outlay of cash to purchase the real estate.
The income approach relies on determining the annual capitalization rate for an investment. This rate is the projected annual income from the gross rent multiplier divided by the current value of the property. So if an office building costs $120,000 to purchase and the expected monthly income from rentals is $1,200, the expected annual capitalization rate is: 14,400 ($1,200 x 12 months) ÷ $120,000 = 0.12 or 12%
This is a very simplified model with few assumptions. More than likely, there are interest expenses on a mortgage. Also, future rental incomes may be more or less valuable five years from now than they are today.
Many investors are familiar with the net present value of money. Applied to real estate, this concept is also known as a discounted cash flow. Dollars received in the future are subject to inflationary as well as deflationary risk, and are presented in discounted terms to account for this.
4. Gross Rent Multiplier Approach
The gross rent multiplier (GRM) approach values a rental property based on the amount of rent an investor can collect each year. It is a quick and easy way to measure whether a property is worth the investment. This, of course, is before considering any taxes, insurance, utilities, and other expenses associated with the property, so it should be taken with a grain of salt.
While it may be similar to the income approach, the gross rent multiplier approach doesn't use net operating income as its cap rate, but gross rent instead.
The gross rent multiplier's cap rate is greater than one, while the cap rate for the income approach is a percentage value. In order to get an apples-to-apples comparison, you should look at the GRMs and rental income of other, similar properties to the one in which you're interested.
Example of Gross Rent Multiplier Approach
Let's say a commercial property sold in the neighborhood you're looking at for $500,000, with an annual income of $90,000. To calculate its GRM, we divide the sale price (or property value) by the annual rental income: $500,000 ÷ $90,000 = 5.56.
You can compare this figure to the one you're looking at, as long as you know its annual rental income. You can find out its market value by multiplying the GRM by its annual income. If it's higher than the one that sold recently—i.e. for $500,000—it may not be worth it, so consider moving on.
5.The Cost Approach
The cost approach to valuing real estate states that property is only worth what it can reasonably be used for. It is estimated by combining the land value and the depreciated value of any improvements.
Appraisers from this school often espouse the highest and best use to summarize the cost approach to real property. It is frequently used as a basis to value vacant land.
For example, if you are an apartment developer looking to purchase three acres of land in a barren area to convert into condominiums, the value of that land will be based upon the best use of that land. If the land is surrounded by oil fields and the nearest person lives 20 miles away, the best use and therefore the highest value of that property is not converting to apartments, but possibly expanding drilling rights to find more oil.
Another best use argument has to do with property zoning. If the prospective property is not zoned for residential purposes, its value is reduced, as the developer will incur significant costs to get rezoned. This approach is considered most reliable when used on newer structures and less reliable for older properties. It is often the only reliable approach when looking at special use properties.
The Bottom Line
There is no one way to determine the value of a rental property. Most serious investors look at components from all of these valuation methods before making investment decisions about rental properties. Learning these introductory valuation concepts should be a step in the right direction to getting into the real estate investment game.
Then, once you've found a property that can yield you a favorable amount of income, find a favorable interest rate for your new property using a mortgage calculator. Using this tool will also give you more concrete figures to work with when evaluating a prospective rental property.