4 Ways to Value a Real Estate Rental Property

Real estate investors value rental property differently from typical homeowners. Besides offering tenants a comfortable living environment, investors buy rental property to secure monthly rental income and capitalize on long-term property value appreciation. This post will explore techniques real estate investors employ for rental property valuation and introduce a novel method for investors to receive automated monthly updates on property values.

The Approach of Comparing Sales

The sales comparison approach (SCA) is a commonly recognized method for determining the value of residential real estate. It helps to answer the common question, are rental properties a good investment? This method involves a straightforward comparison of similar homes that have recently sold or rented in the local area. Investors typically prefer reviewing an SCA over a significant timeframe to identify emerging trends.

Within the SCA, property values are assigned based on specific attributes or features to establish a relative price. These values are often influenced by characteristics like the number of bedrooms and bathrooms, presence of garages or driveways, pools, decks, fireplaces, essentially, any distinguishing feature that makes a property stand out and noteworthy.

Capital Asset Pricing Model

The Capital Asset Pricing Model is possibly the most intricate approach to determining the value of a rental property based on its income. Per the Corporate Finance Institute, CAPM delineates the correlation between an asset's expected return and the risk tied to its investment. This expected return merges the risk-free return (such as that from a 10-year US Treasury bond) with a risk premium.

Applying the capital asset pricing model to evaluate a rental property involves reviewing several aspects, such as its age, state, location, and neighborhood rating. Again, property age and condition are important, along with operational costs, the potential for rental earnings, and the following net cash flow.

While CAPM indicates that real estate investors can see higher returns only by assuming increased risks for potentially greater rewards, some investors maintain that it is indeed feasible to identify rental properties in the marketplace that offer a proportional mix of risk and reward. For those looking to sell my land, understanding this balance can be crucial in making informed decisions.

Cost Approach

The cost method is commonly used to assess rental properties in scenarios where recent sales data is limited and for properties currently not generating income. The underlying principle of this approach suggests that an investor in real estate should not pay more for a resale property than the cost of constructing a similar home from the ground up. When calculating the value of a rental property through the cost approach, the following formula is applied:

Value of Property = Cost – Depreciation + Land Value

Two key valuation methods employed in the cost approach are reproduction and replacement. The reproduction method determines the value of a rental property by considering the costs associated with replicating the home using the same materials, fixtures, and floor plan. Conversely, the replacement approach factors in the expenses of new materials, an updated floor plan, and modern construction techniques.

Gross Rent Multiplier Approach

Like the income method, the Gross Rent Multiplier technique calculates property value using rental income. It is commonly applied to residential investment properties, encompassing single-family residences and multifamily real estate. 

In contrast to the income approach, this method overlooks the property's operational costs such as property taxes, management fees, or mortgage payments, rendering it a more approximate evaluation. Moreover, it assesses the worth of a rental property by considering the annual income and purchase price of a comparable property, resembling the sales comparison approach.

Endnote

Serious investors often analyze elements from various valuation methods before deciding on rental property investments. Understanding these basic valuation principles is a solid starting point for entering the real estate investment field.