Property valuation is an important concept in the real estate investing business. If investors don’t know the value of investment properties, they wouldn’t know how much to put as down payment for the mortgage, the right amount of rent to charge their tenants, the expected rental expenses (maintenance, taxes, insurance…) etc.
An investment property is like a money machine. A number of factors go into determining the value of that machine. Therefore, real estate investors use different valuation methods, some of which we’ll walk you through in this article. There is no right or wrong method; each one applies in different circumstances. With that in mind, let’s look at five property valuation methods used in real estate investing.
Property Valuation Method 1: Sales Comparison
This is the most common method in determining the market value of real estate properties. Under the sales comparison method, the property valuation entails comparing the subject income property with others in terms of sales price – hence the name of this method. However, not just any property works for comparison. The properties have to be similar and sold recently or are currently being offered for sale in the same or similar locations. In real estate investing, these are called comparables (comps).
Related: How Do You Find Real Estate Comps?
Real estate investors mostly use this method for residential properties especially single-family homes. To accurately compare investment properties, they must be similar in terms of square footage, the number of bedrooms and bathrooms, condition, age, interior, and the housing market’s conditions during the purchase. Together with the location, these factors can influence the investment property’s market value and significantly alter its sale price.
When following this property valuation method, a real estate investor needs to use at least three or four comparables. The characteristics of these properties are noted and appropriate adjustments are then made to the sales prices in order to arrive at the final value of the subject investment property. Wondering where you can find comparables in your housing market?
Using Mashvisor, property investors have access to comps that can be easily downloaded using the Export Neighborhood Report functionality. You can also set a number of filters to control the type, size, age, and many other features of the properties that you want to compare before downloading an Excel sheet containing all the details and info you need about these properties to compare them for property valuation.
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Property Valuation Method 2: Cost Approach
The concept of the cost approach applies on the basis of how much it costs to rebuild the property you want to buy today. The whole purpose of this property valuation method is that a real estate investor shouldn’t buy an income property for more than what it would cost to build a new, similar property. Therefore, we include the value of the land in the replacement costs. So, what is the process of property valuation when following this method?
First and foremost, investors determine the value of the target income property using comparables. The sales comparison approach is also used to find the value of the property’s land as well – finding similar plots of land that were sold recently or are currently being offered for sale. Then, you calculate the costs of building the property and deduct the additional depreciation costs. Finally, the real estate investor would compare the costs of buying an investment property vs the costs of reconstructing a similar one in today’s market and determine which investment decision is more profitable.
This method of property valuation is not used for residential properties. Instead, it’s best for real estate properties that are specialized, unique, and are usually constructed but not sold such as schools, government buildings, religious institutions, hospitals, etc.
Property Valuation Method 3: Gross Rent Multiplier
The gross rent multiplier is another method for valuing properties that property investors should keep in mind when thinking of buying an income property. The formula for calculating the GRM is simply dividing the purchase price of the investment property by its annual rental income (before deducting the different expenses and running costs like utilities, property taxes, insurance, etc.).
For example, let’s say that the asking price for an investment property is $250,000 and it has gross rents of $40,000 per year. The result is 6.25. This number means that the cost to purchase this investment property is 6.25 times larger than the annual gross rental income it generates. Real estate investors typically go for properties with lower GRM (in the range of 4 – 7) because it means it’ll take less time for the property to pay off its price.
As you can see, the gross rent multiplier is a quick property valuation method to analyze the potential profitability of a rental property. It’s a simple way for real estate investors to decide whether or not a certain property is worth their time and money. Knowing the GRM allows investors to determine if the property’s price is in line with the housing market prices and calculate its potential rental income.
This property valuation method, however, has some limitations. The GRM only takes into account gross rents and doesn’t account for factors like vacancies, operating expenses or property tax and insurance – all of which can vary drastically from one property to another. Thus, to ensure an accurate property analysis, real estate investors need to use other metrics and valuation methods alongside the gross rent multiplier.
Property Valuation Method 4: Capitalization Rate
The cap rate is something you’ll hear about all the time in the real estate investing business. Together with the gross rent multiplier, they make “The Income Approach.” This property valuation method also has a formula which is the net operating income divided by the cost. So, if an income property has a 7% cap rate, what does this number mean?
One way of looking at cap rate is by saying that this property produces 7% of its cost in net operating income. So, cap rate can be a good property valuation method when comparing two or more investment properties. When a real estate investor knows the cap rate of each property, he/she can judge which one is producing the highest percentage of NOI. In addition, the cap rate is related to risk – high cap rate means high risks (in theory). Nonetheless, higher risks can mean more profitability in real estate investing, which is why property investors look for properties with high cap rates.
While the cap rate does consider the rental expenses, it does not, however, take financing into account and only assumes that you’re buying a rental property fully in cash. For accuracy, we recommend using a cap rate calculator.
Property Valuation Method 5: Cash on Cash Return
The final approach for analyzing investment properties and their profitability is through calculating the cash on cash return. Following this property valuation method, real estate investors take the net operating income that the property generates and divide it by the total cash investment. This means that the CoC return takes into account how you decide to finance a rental property (paying all cash or taking out a mortgage loan).
Knowing the cash on cash return on investment properties not only is one way to determine which yield a better return on investment but to also determine the financing method to go for. For example, one rental property might have a CoC return of 6% when financed with all cash but, when taking a loan, it’ll give you a 2% CoC return. Thus, this property valuation method lets you see which financing method makes your investment worthwhile and gives you a better return on investment.
Did you know: Mashvisor’s investment property calculator gives you readily calculated cash on cash returns of investment properties across the US housing market? When you’re searching for a property on Mashvisor, choose your preferred financing method, click on a property or a neighborhood, and you’ll get the traditional and Airbnb CoC return!
To start analyzing and comparing investment properties in your city and neighborhood of choice, click here.
Buying a rental property is a great way to make money in real estate. However, it’s important for real estate investors to know the value of a property to decide whether or not it’s worth investing in. There’s a number of property valuation methods to do so but remember, there is no ultimate one. Each approach works in a different situation, so don’t rely only on one of them and ignore the rest! Things like the type of property, rental income, expenses, financing method, and the location should be taken into account as well. With the right tools, property valuation becomes second-hand nature for successful real estate investors.
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