Investing in real estate is an excellent way to generate a steady stream of income. It has many added benefits as well, such as rental property tax deductions. In order to fully gain a substantial income from your investments, you must choose your investment properties wisely. If you fail to assess their value properly, you risk overpaying and reducing your overall return on investment.
So how do you value a rental property? There are many different methods at your disposal. By using these valuation tools, you can estimate each property’s rental income potential, cash flow, and return on investment. Understanding the ins and outs to valuing a rental property is an essential step in determining how to start a rental property business. Valuing a property correctly will set you up for more knowledgeable financial decisions before you make a mistake.
In this article, you’ll learn about four different rental property valuation methods, as well as a few tips on how to maximize the value of your investment.
4 Simple Rental Property Valuation Methods
To estimate rental value, you have a few different methods to choose from. Let’s take a look at each one:
#1 Sales Comparison Approach
The most popular rental property valuation method is the Sales Comparison approach. It’s the go-to method for real estate agents and appraisers alike.
As the name suggests, this approach assesses a potential investment property’s value by comparing it to other recently sold homes.
To improve the accuracy of the estimate, you’ll want to start by finding three to five properties that are similar to the one you’re considering investing in, in terms of:
- Specifications – The features of a property have a notable impact on its value. Try to find homes that have the same:Number of bedrooms
– Number of bathrooms
– General square footage
– Lot size
– Pool or no pool
- Age and condition – Home appraisals are greatly dependent on the condition of the home. An older house without any upgrades won’t be as valuable as one that’s brand new or recently renovated. Thus, it’s crucial to find comparable properties that are in the same general condition as the one that you’re evaluating.
- Neighborhood – If you know anything about real estate, you’ve heard the saying, “Location, location, location.” Ideally, each of your comparison properties should be located in the same neighborhood. This way, their prices will reflect what that neighborhood has to offer, whether that’s good schools, proximity to nightlife, low crime rates, or great views. This will largely contribute to the type of tenant you will attract and the rent price you can charge.
- Sale date – Since the real estate market fluctuates constantly, properties sold long ago won’t be of any relevance. Instead, look for properties that were sold in the last few months—the more recent the sale, the better.
Multiply Square Footage With Comps
Once you’ve found your comparison properties, it’s time to do the math:
- Start by dividing the price of each comparison property by its square footage
- Next, calculate the average price per square foot of all these properties
- Finally, multiply your potential investment property’s square footage by this average
Just like that, you have your estimated rental property value using the Sales Comparison approach.
#2 Gross Rent Multiplier Approach
Another option for rental property valuation is the Gross Rent Multiplier approach. Gross rent multiplier (GRM) is a metric that assesses whether a property’s selling price is a good deal. In turn, this valuation technique focuses on an investment property’s income potential.
To calculate a potential investment property’s GRM, you’ll need its asking price and rental income estimate on hand. To estimate your annual rental income, review some local rentals, and see what they’re charging for a monthly rent. Once you have those metrics handy, input them into this formula:
- Gross Rent Multiplier (GRM) = Purchase Price / Annual Gross Rental Income
Ideally, you want your GRM to be on the lower side. A GRM between four and seven is ideal. Properties with low GRMs take less time to pay off, so they’ll become profitable much faster. In contrast, properties with a high GRM may not be the best investment option for a real estate investor.
A GRM Calculation Example
Let’s say you’re thinking about investing in a property that costs $750,000.
After reviewing similar rental properties in the area, you can reasonably expect to earn $90,000 of gross rental income each year.
You divide $750,000 by $90,000 to get a GRM of 8.33. This tells you that it will take a little over 8 years to pay off the property if it goes according to plan. That’s not far from the GRM sweet spot, but it’s a little high. Thus, you may be better off finding a property with a lower GRM.
Take Gross Rent Multiplier With a Grain of Salt
One downside of the Gross Rent Multiplier approach is that it fails to factor in operating expenses, such as:
- Property taxes
As a result, GRM should not be the sole valuation tool you use. However, when used in conjunction with other methods, it can help guide your investment decision.
#3 Income Approach
The Income approach is another valuable real estate valuation method. It’s more accurate than the Gross Rent Multiplier approach because it factors in operating expenses. The Income approach uses the following formula to compare the potential income of a rental property with its initial investment:
- Property Value = Net Operating Income / Capitalization Rate
Net operating income is the gross annual income of the rental property, minus all of the operating expenses, including:
- Property taxes
- Insurance premiums
- Management fees
- Maintenance and repairs
- Accounting fees
- Legal fees
- Potential vacancies
The capitalization rate is a metric that estimates a property’s return on investment. You can calculate it by dividing the net operating income by the property’s selling price. You can also estimate the capitalization rate by referencing comparable rental properties on the market.
Important Considerations of the Income Method
When using the income method, you’ll have to estimate operating expenses to the best of your ability. This can be a time-consuming process, and it involves a lot of guesswork.
Furthermore, you’ll have to estimate potential vacancies. You can get an idea of vacancy rates by looking at comparable rental properties in the area and what they charge as a monthly rent price.
While the Income approach requires some research, it offers a more accurate assessment of a property’s value than other methods.
#4 Cost Approach
The last real estate valuation method is the Cost approach. This technique compares the cost of the property with the cost of building an identical property from scratch. The premise behind the Cost Approach is that investors shouldn’t purchase an investment property if they could build it themselves for less.
The Cost approach uses this basic calculation:
- Property Value = Cost of Land + Cost of Construction (minus) Depreciation
In other words, it adds up the cost of purchasing the land and constructing the building. Then, it subtracts any obvious depreciation to the property, given its current condition. This method is most accurate when the property is new since there is no depreciation to account for.
Drawbacks of the Cost Approach
Compared to the Sales Comparison approach and the Income approach, the Cost approach is less reliable. That’s because it involves many assumptions about:
- The value of the land – You may not be able to find an equivalent piece of land for sale on the market. Thus, it can be tricky to estimate the land’s value.
- The cost to build an identical home – Building a home is an involved process. Without knowing every detail about the materials used, you may arrive at an inaccurate assessment.
- The exact amount of depreciation – Calculating depreciation is also complicated and imperfect, especially when basing your assessment on a shallow understanding of the property.
As you can see, there’s a lot of subjectivity involved in the Cost approach. However, it can still help you decide whether an investment property is a worthwhile venture.
How to Increase the Value of a Rental Property
So what if you already own a rental property and want to maximize its value?
Here are some steps you can take to enhance the rental value of property as a landlord:
- Spruce up the curb appeal – The first thing potential buyers and tenants see is the outside of your property. It will either impress them or put them off. This first impression is crucial. By giving the property’s exterior a fresh paint job, investing in landscaping, and repaving old concrete, you can easily enhance your curb appeal and make an outstanding first impression on a prospective tenant.
- Renovate kitchens and bathrooms – The rooms with the greatest potential for increasing your property’s value are the kitchen and bathrooms. By swapping out old appliances for new ones, modernizing the cabinetry, and investing in better quality countertops, you can quickly boost your property’s selling price.
- Install new flooring – In rental properties, hardwood floors are coveted due to their sleek look. In fact, in 2019, hardwood floors were the preferred flooring material. Not only are they easier to clean, but they don’t trap any odors. In a rental property, this is very important.
- Add valuable features – Renters and homeowners appreciate air conditioning, on-site washers and dryers, dishwashers, outdoor living areas, and off-street parking. If you can add any of these features to your property, you’ll make it much more valuable.
- Use a property management company – Lastly, properties that are well-maintained hold their value longer. That’s because they counteract depreciation by keeping up with repairs and improvements. As you know, depreciation reduces a property’s value. By hiring a dedicated property management company, you can maximize your investment value for the long term.
Once you’ve made all the necessary adjustments to your real estate, it’s important to understand how to advertise a rental property. This is an important aspect as it helps prospective tenants understand the property value and increases its place in the market.
Great Jones: Property Management Done Right
Now you know how to value a rental property and how to increase its value. If you need help with either task, reach out to Great Jones.
Great Jones is a premier property management company that provides many services, such as:
- Investment property valuation, renovation, and management
- Property maintenance
- Rent collection
- Property inspection
- 24/7 tenant customer support
- Prospective tenant screening
- Data-driven marketing
And with services in property management in Jacksonville, FL and property management in Indianapolis and beyond, every real estate investor can feel supported. By partnering with Great Jones, you can maximize your real estate investment and sit back as the experts take these tasks off your hands.
The Balance. Calculating the Gross Rent Multiplier (GRM) and Why It’s Important.https://www.thebalancesmb.com/how-to-calculate-and-use-the-gross-rent-multiplier-grm-2866791
Dumpsters.com. Residential Flooring Trends in The United States. https://www.dumpsters.com/research/flooring-trends