Real estate investors value rental property differently from regular homeowners. In addition to providing tenants with a nice place to live, investors also purchase rental property for the potential monthly rental income and increase in property value over the long term
In this article, we’ll discuss 5 methods for rental property valuation that real estate investors use, along with a new way for investors to automatically receive updated property values each and every month.
Key takeaways
- Rental property valuation is different from valuing a primary residence because of the potential for monthly rental income.
- Methods for valuing a rental property include gross rent multiplier, sales comparison approach, income approach, and the capital asset pricing model.
- Online property valuations calculators simplify the process of forecasting the potential return of a rental property.
- Automatically updating the estimated value of a rental property can provide more accurate measures of potential financial performance and owner’s equity.
5 unique ways to value a rental property
Here are 5 different methods that real estate investors use to determine the possible value of a rental property.
Keep in mind that there isn’t a single right way to value a property. Investors may wish to use more than one way to value a rental property to generate a range of potential values.
1. Sales comparison
The sales comparison approach is used by appraisers and real estate agents to determine how much a home is worth by looking at recent comparable sales.
Also known as an SCA, comps, or the price-per-square foot approach, the sales comparison approach compares similar homes that have recently sold over a specific time frame.
Ideally, comparable properties have sold within the past 30 days or so, depending on the level of activity in the local real estate market. The best comparable sales are homes with characteristics as close as possible to the property being valued, such as similar square footage, age, number of bedrooms and bathrooms, and lot size.
For all practical purposes, the sales comparison approach does not value an investment property differently from an owner-occupied property.
For example, if 5 similar homes used as primary residences recently sold for between $150 and $160 per square foot, a 1,500 square foot rental property with similar characteristics to the comps would also be valued at between $225,000 and $240,000.
2. Income approach
The income approach for valuing a rental property considers the net operating income (NOI) the property is generating compared to the property value or purchase price. NOI only includes normal property operating expenses and does not take into account mortgage and interest payments, capital repair costs, and depreciation expense.
Also known as the capitalization rate or cap rate approach, cap rate is the percentage return calculated by dividing the first year of NOI by the property price:
- Cap Rate = NOI / Property Price or Value
To illustrate how the income approach is used for rental property valuation, let’s assume the rental income from a $175,000 home is $20,000 per year. Operating expenses average 36% ($7,200) of the annual income, generating an NOI of $12,800
By using the income approach, the estimated percentage return of the rental property is:
- $12,800 NOI / $175,000 property value = 7.31%
Generally speaking, the higher the cap rate or potential return of a rental property is, the better the investment may be.
However, a rental property with a cap rate significantly higher than similar rentals may not be as profitable as it seems. For example, a property may be underpriced because the property requires a lot of repairs.
On the other hand, an investor may be able to gradually increase the NOI from a low cap rate property by increasing the rent each year while keeping operating expenses under control.
3. Cost approach
The cost approach is often used to value rental properties where recent sales are difficult to find, and for property that currently is not generating income. Implicit to the cost approach is the idea that a real estate investor will not pay more for a resale property than it would cost to construct the same home from the ground up.
The value of a rental property using the cost approach is based on the following formula:
- Value of Property = Cost – Depreciation + Land Value
Two main valuation methods used in the cost approach are reproduction and replacement.
The reproduction method values a rental property based on the cost of reproducing the home using the same materials, fixtures, and floorplan. On the other hand, the replacement approach uses the cost of new materials, along with an updated floor plan and today’s construction techniques.
4. Gross rent multiplier
Also known as GRM, the gross rent multiplier approach is one of the simplest ways to determine the fair market value of a property. To calculate GRM, simply divide the current property market value or purchase price by the gross annual rental income:
- Gross Rent Multiplier = Property Price or Value / Gross Rental Income
For example, if a single-family rental home is listed for sale with an asking price of $175,000 and the annual gross rental income is $20,000, the GRM is:
- $175,000 property price / $20,000 gross rental income = 8.75
The GRM method of valuing a rental property provides investors with a rough idea of how many years it would take to pay off the property based on the gross cash flow generated.
In the example above, it would take a little less than 9 years to pay off the property. However, gross rent multiplier doesn’t take into account operating expenses such as property management, maintenance and repairs, property taxes, insurance, or vacancy rate.
While a rental property might have a lower GRM – and appear to have more value for an investor – it may also require more ongoing maintenance or significant capital repairs such as a new roof or heating and cooling system.
5. Capital asset pricing model
The capital asset pricing model (CAPM) is arguably the most complicated method for valuing a rental property based on income.
According to the Corporate Finance Institute, CAPM is a model that describes the relationship between expected return and the risk of investing in an asset. The expected return is equal to the risk-free return (such as the yield on a 10-year US Treasury bond) plus a risk premium.
Rental property valuation using the capital asset pricing model takes into account various factors such as property age, condition, location, neighborhood rating, property age, condition, operating expenses, potential rental income, and subsequent net cash flow.
In theory, CAPM suggests that the only way for a real estate investor to earn more is by accepting a higher level of risk in exchange for the promise of more reward. However, some real estate investors may argue that in the real world, it’s possible to find rental property that provides a balanced mix of risk and reward.
How rental property valuation changes over time
All of the methods discussed value a rental property at a specific point in time, based on certain assumptions. However, during the time an investor holds a property, rental property value can increase or decrease from year to year.
The chart below illustrates how rental property valuation might change over time using some different valuation methods for a 1,052 square foot single-family rental home:
Why investors automatically update property value
Imagine for a moment that the chart above used the same property value year after year. GRM would consistently decline, and the cap rate would significantly increase each year, providing the real estate investor with inaccurate valuation metrics.
Even worse, the owner’s equity on the real estate balance sheet (calculated by subtracting liabilities from asset values) would be understated, indicating that the owner’s net worth in the property is less than it really is. Yet surprising as it might seem, that’s exactly what most rental property financial software does.
That’s also why Stessa has introduced a new valuation feature for single-family rental properties. Estimated rental property valuations are updated monthly, using the same type of data-based valuation tools that institutional investors have used for decades.
Of course, there’s no guarantee that a rental property will sell for the estimated value, because real estate market conditions are constantly changing.
However, investors using Stessa’s new estimated valuations feature have a much better idea of the actual financial performance of each rental property monitored using Stessa, along with a more accurate assessment of owner’s equity.
Knowing the potential net profit in a rental property makes it easier to decide if the time is right to think about refinancing, or pulling out cash to fund the down payment for another rental property.
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