Real estate investors want and need to know what their rental property is worth, but you may not be confident about the best way of valuing your assets. In reality, the appropriate method may differ depending on the type of property, the use, and even the location. So let's look at some options and the pros and cons of each.
Sales comparisons.
Comparison prices, also known as “comps," is looking at the price for which similar properties have sold. For example, suppose you own a rental property that is a 1,500 square foot, newer construction, three-bedroom, two-bath home in a suburban neighborhood with a pool and no HOA. You can research what similar homes in the vicinity have sold for within the last few months to develop a good idea of what you can sell your property for. Of course, there are always differences, but typically it doesn’t matter whether the residential property is owner-occupied or used for an investment. The sales comparison method is sometimes called a market approach.
For residential rentals, comparisons are the most widely used valuation method. It works well, assuming that the property you need a value for is similar to others in the immediate area. However, this tool can have some drawbacks if the property is unique. As a result, it's not frequently used for industrial or office spaces.
Gross rent multiplier.
The gross rent multiplier uses the estimated rental income to calculate how many years you need to pay off the property. For example, if you have a residential rental for sale at $600,000 and an annual rent of $30,000, you divide the price by the income ($600,000/$30,000 = 20). That equation shows it would take 20 years to pay for the property. However, this methodology does not include the cost of maintenance, repairs, taxes, insurance, financing, or vacancies.
Direct income capitalization approach.
This formula determines the property value by calculating the net annual operating income and dividing it by a pre-set capitalization rate. The equation is Market value= NOI/Capitalization rate. The investor can estimate the applicable capitalization rate by looking at other similar properties, so this method relies, to some extent, on the ability to compare similar sales. If that's not feasible, this method won't succeed. Also, this approach is valid for stable properties, meaning that they rent at market rates and with a typical vacancy for the area.
Less common approaches.
The cost approach and the capital asset comparison are two additional but less frequently used methods. The cost approach calculates how much it would cost to build the property from scratch, including land acquisition, construction, permits, and start-up. This formula is sometimes employed when there are no relevant comparable sales, and the income tool isn’t applicable (perhaps the property has been vacant or changed purposes).
The capital asset pricing model is even less commonly used and somewhat more complex than the others. It compares the expected return of an investment with its risk. Using the expected return of a Treasury Bond (with no accompanying risk), the contrasting property’s anticipated return must have a high enough differential to outweigh the higher risk. However, that model goes beyond the value determination issue here.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Programs that depend on tenants for their revenue may suffer adverse consequences because of any financial difficulties, bankruptcy or insolvency of their tenants.
