The most important thing you should do before deciding to invest in a certain income property is to value this property.
So, you wonder HOW TO VALUE AN INVESTMENT PROPERTY? Well, first of all, let us tell you that though somewhat similar to valuing stocks, valuing rental properties is actually quite different. There are many ways on how to value an investment property depending on what you are interested in. Are you planning to sell your new investment soon or keep it for many years? Are you paying fully in cash or taking a loan? What kind of data do you have available?
In this article we look at some of the most commonly used and most useful methods on how to value an investment property to guide you through the process of deciding whether you should buy an income property or not.
Income Approach/Capitalization Rate
If you are planning to keep a rental property for a while in order to make money out of it every month in the form of rent, then you should choose the income approach when you decide how to value an investment property. This method relies on calculating the capitalization rate, or cap rate, for the property, which measures the rate of return of an income property regardless of the method of financing. In a sense, this is a quite simplified approach as in the real world you will most likely need to pay interest on your mortgage which the cap rate does not take into account.
So, how to calculate the cap rate?
Cap Rate = NOI/Purchasing Price
NOI stands for net operating income, and it equals the annual rental income (monthly rent x 12) minus annual operating costs. So, let’s say that the property you are contemplating is being sold for $200,000, and you expect to be able to rent it out for $1,400 per month, while you estimate your annual operating costs at $4,000.
Cap Rate = (12 x $1,400 – $4,000)/$200,000 = 6.4%
Should you buy this income property? Well, probably not. While there is no agreement among experts on what’s a good cap rate, most tend to say 8%-12%.
Cash on Cash Return
Let’s face it. Most investors need to take a loan in order to finance the purchase of an income property, so let’s look at a more real-world example. When you wonder how to value an investment property, you can also use the cash on cash return you could expect. One benefit of this approach is that it allows you to factor in the loan that you will need to take. Let’s look at an example with a mortgage.
Cash on Cash Return = NOI/Total Cash Investment
If you want to buy a property worth $200,000 with a 20% down payment:
Down Payment = 20% x $200,000 = $40,000
You need to invest another $5,000 to rehab the property, so:
Total Cash Investment = Down Payment + Rehab Costs = $40,000 +$5,000 = $45,000
Now, calculating the NOI is a bit more complicated:
NOI = (Annual Rental Income – Operating Costs) – Debt Service
Debt Service = 6% x ($200,000 – $40,000) = $9,600 in case of 6% interest rate
NOI = (12 x $1,400 – $4,000) – $9,600 = $3,200
Cash on Cash Return = $3,200/$45,000 = 7.1%
Again, there is no right answer to the question of what constitutes a good cash on cash return, but most say it should be at least around 10%.
Related: What is a Good Cash on Cash Return?
Gross Rent Multiplier
Another answer to the question how to value an investment property is through the gross rent multiplier (GRM). How to calculate the GRM?
GRM = Purchasing Price/Annual Rental Income
GRM = $200,000/12 x $1,400 = 11.9
And what does this number tell us? Generally, you want the GRM to be lower because it means you are making more compared to your initial investment. One thing you could do with the GRM is compare it to similar properties in your area. Another common rule of thumb you can use is that income properties with GRM below 10 or close it are likely to generate neutral or positive cash flow, and that’s what you want as a real estate investor. Alternatively, if the GRM is above 15, the cash flow is likely to be negative, so you should stay away from such investments.
Capital Asset Pricing Model/Return on Investment
If you aim for an even more realistic approach when you decide how to value an investment property, you need to consider the risk and opportunity cost associated with this investment. So, we could use the capital asset pricing model (CAPM), which requires the calculation of the return on investment (ROI). The return is the annual income from rent.
ROI = Annual Rental Income/Total Cash Investment
Annual Rental Income = 12 x $1,400 = $16,800
If we assume we paid in cash for the rental property and needed $5,000 for rehab costs:
Total Cash Investment = $200,000 + $5,000 = $205,000
ROI = $16,800/$205,000 = 8.2%
So what do we do with this number? We compare it. If the ROI for your investment property is less than the expected return on a risk-free or guaranteed investment (such as US Treasury Bonds), forget about it. There is no point risking your money by investing it in real estate.
In our discussion of how to value an investment property, all methods mentioned so far lack one significant feature of real estate properties – that they generally tend to appreciate in value over time. If you plan to sell your income property at some point, you might want to consider how much its value will increase in the coming years. However, there is no way to predict this appreciation. Any number you come up with will be speculation. Thus, it is better not to rely on property appreciation only.
These are the five most popular approaches to the dilemma of how to value an investment property. To help you in the process of evaluating thousands of rental properties throughout the US, don’t hesitate to use Mashvisor to obtain many useful metrics that you will need in your calculations.