Rental property valuation is one of the most important aspects of investing in real estate and building wealth. To make good investment decisions, you need to do a thorough investment property analysis to estimate how profitable the property will be.
There are several things an investor needs to assess before purchasing a rental property, including the rental income, cash flow, return on investment, and property value. In this blog, we are going to focus on how to value rental property.
Property valuation is the process of determining the fair market value of a property for sale. It is the price that the property would sell for if both the seller and buyer have a reasonable understanding of the relevant facts and are not under any pressure to sell or buy.
Why Should You Value Rental Property?
Unlike corporate stocks that are traded on a daily basis and are similar, real estate transactions take place less frequently and every property has unique features. This makes determining property value more difficult. Therefore, knowing the value of a rental property is very essential during real estate transactions.
Property valuation helps you determine the right price to offer and avoid overpaying. It also helps you identify and take advantage of investment properties that are below market value. For instance, a distressed seller who needs to sell the property as fast as possible is likely to sell it at a discount.
So, how do you estimate a rental property’s value? Well, there is no one way to do it. Here are the most common ways to value real estate.
Rental Property Valuation Methods
The following are the three main property valuation methods for rental properties:
1. Sales Comparison Approach
The first option to consider when thinking of how to value rental property is the sales comparison approach. This is the most popular valuation method used by real estate investors to evaluate investment properties. It involves assessing the sales prices of recently sold properties that are similar to the rental property valued and located in the same area (real estate comps).
For this rental valuation method to be accurate, you should identify three to five comparable properties that are as similar as possible to the property being valued. The sale date of the real estate comps should also be as recent as possible. Since you are trying to find the current value of a real estate rental property, older property sales won’t give you an accurate value estimate.
Moreover, the comps should be located as close as possible to the subject property. It means that they should be in the same housing market and neighborhood.
However, no two properties are exactly identical. Therefore, simply looking at the sales price of comparable properties is not enough to give you accurate results. You need to account for the differences between the subject property and the comps by making adjustments to the sales prices.
The most efficient way to find real estate comps is to use Mashvisor’s rental property calculator. The tool will give you a list of readily available comps for any rental property for sale in the US, whether on Mashvisor’s platform or off-market.
2. Gross Rent Multiplier Approach
The gross rent multiplier is a method of valuing rental property based on the rental income that it can generate in a year. It is calculated as follows:
GRM = Purchase Price / Annual Gross Rental Income
For instance, a GRM of 5 means that the purchase price of the rental property is 5 times larger than the generated annual gross rental income.
When analyzing an investment property for sale, property investors should find properties with a lower gross rent multiplier (4-7). A lower GRM means that the rental property will take less time for it to fully pay off its price.
It is a quick and simple way for investors to assess whether buying a rental property makes financial sense or not. The main drawback of the gross rent multiplier approach is that it does not take into account operating expenses like property taxes, insurance, and vacancies. The gross annual rental income does not factor in the rental property expenses.
And as you know, rental property expenses will vary from one rental to another. Therefore, on its own, the GRM method is not very reliable. Investors should use it along with other property valuation calculations.
3. Income Approach
The income approach is another method that real estate investors should keep in mind when looking into how to value rental property. It is used to determine property value by dividing the net operating income (NOI) of the income property by the capitalization rate (cap rate).
Property Value = NOI / Cap Rate
Cap rate is a property metric used to estimate the return on investment of an investment property regardless of the financing method. It is usually calculated by dividing the NOI by the property price. Cap rate estimates can easily be obtained from real estate comps. Cap rates are also automatically calculated by Mashvisor’s calculator.
The advantage of using the income approach is that it provides a quick estimate of the rental property value.
Rental Property Valuation in Practice
When it comes to doing a rental property valuation, investors don’t use a single approach, but a combination of a number of things. Whether you’re doing it by hand or if you’re using a rental property valuation calculator, the valuation of a rental property needs to take several aspects into consideration.
For example, doing comps using a rental property valuation spreadsheet is an approach that can be used not only for comparing property sales but for other metrics as well. Using the same logic of the sales comparison approach, investors can compare properties based on their return on investment or rental income, or any other value that they choose.
In such a case, the one aspect of that approach that shouldn’t change is that properties should be similar and located in the same area as the one you’re analyzing.
Rental Property Valuation Using ROI Metrics
If you ask rental property investors what metrics they use the most when comparing rental properties for real estate investing, there are two metrics that are used the most:
- Cap Rate
- Cash on Cash Return
The above metrics are most commonly used in the valuation of rental property based on its long-term investment value. Since both metrics take all costs and expenses into consideration, they typically provide the most realistic projections regarding the future of your investment.
For this reason, we highly recommend using a rental property valuation spreadsheet with one or two of these metrics on it.
Using a Rental Property Valuation Calculator
The easiest and best method that you can use for property rental valuation is to use a rental property valuation calculator, like Mashvisor’s.
Mashvisor is a real estate investment platform that specializes in rental property valuation and analytics. The platform offers a wide range of real estate investment tools and features, one of which is a rental property calculator. The calculator can help you significantly in the valuation of rental property as it is an easy-to-use customizable tool with many useful features.
Not only does the calculator include all relevant expenses in its calculations and uses values such as cap rate and cash on cash return, but it also provides you with rental property valuation spreadsheet comps. By comparing each property with similar properties around it, the tool can tell you whether a rental property’s valuation matches your investment criteria or not.
Investing in Rental Properties: Is It Worth the Hassle?
Rental properties have been the most popular type of real estate investment properties for a very long time. But what makes rental properties appeal to investors so much? The answer is passive income.
Although it’s not precisely a passive income, the profit that rental properties make on a monthly basis is a very desirable thing for most investors. Who doesn’t like the idea of owning a property that generates at least a few hundred dollars each month?
And while many investors choose to manage their own rental properties, which can take time and effort especially if you’re running short-term vacation rentals, hiring a professional property manager is an option. Of course, keep in mind that property managers aren’t cheap, and they make up a considerable expense that you should include in your calculations to make sure you can afford it.
On the other hand, if you own several rental properties or a multi-family property, then budgeting for property management is considered a must.
The Answer Depends on Your Rental Property Valuation
Basically, not all rental properties are profitable when taking all running costs and expenses into consideration. This is very important to keep in mind, especially if you’re using a mortgage and you’re relying on the property’s rental income to cover for your mortgage payments.
Typically, when doing a rental property valuation, you want to include as many expenses as possible in order to achieve accurate results in your calculations.
Experienced investors can easily identify properties that might be too expensive to run or that might not generate enough rental income to cover their cost. However, even beginner investors can reach the same conclusions when doing property rental valuation using a calculator or a spreadsheet.
In the end, it all comes down to whether the property is making more money than it’s costing you. Of course, it also means that your assessment of the property’s rental income potential should also be accurate, which you can learn from doing rental comps in the location you’re investing in.
Finally, if you’re using a mortgage, it’s important to include that in your calculations and use the cap rate metric to project the return on investment. It allows you to see if your property will still be generating a profit after covering all of its expenses as well as the monthly mortgage payments.
The Bottom Line
Learning how to value rental property is a great step to determining the viability of a rental property for sale. Before you enter into a purchase agreement, always make sure that you know the value of the investment property for sale.
There are several ways in which an investor can determine the value of a rental property for sale. But which rental property valuation method should you use? Well, savvy real estate investors examine the components of each method to make better investment decisions.
However, using Mashvisor’s calculator eliminates the need for all that work. Using the said tool will help you determine the fair market value of the rental property you are evaluating. You can also calculate other key real estate metrics, such as cash flow, cash on cash return, cap rate, and Airbnb occupancy rate.
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