Investing in a rental property is the ideal strategy to generate wealth in real estate and build a passive and reliable stream of income. However, this investment requires pragmatic decisions, research and a diligent property analysis to understand how profitable your chosen investment is likely to be. There are multiple aspects that you need to consider and analyze as an investor before purchasing your chosen rental property.
These include the return on investment, projected cash flows, rental income, and the market value of the property. In this article, we will walk you through the basics of property valuation, and help you understand how you can value your rental property.
Here’s everything you need to know:
What is Property Valuation & Why is it Necessary?
Property valuation refers to the process of establishing the fair market value of a property that is being sold. It basically refers to the selling price of the property should the buyer and seller come to an understanding over its condition and are not pressured to ensure a sale or purchase.
Why is property valuation necessary? Unlike the stock market, where corporate stocks are traded day after day under similar rates, property transactions are less frequent, and each property has its own unique features and aspects. This is primarily why it can be more challenging to establish the value of a property. It is important to understand the value of a rental property to make strategic real estate transactions.
The art of property valuation allows sellers to market their property with a fair and attractive price while investors can avoid overpaying. It also allows investors to identify and benefit from property investments that are being marketed with listings below market value. For instance, distressed properties that are inching towards a foreclosure can be bought with significant discounts.
Property Valuation Methods
You can estimate the value of a rental property through multiple methods. There are three main valuation methods discussed below for your reference.
Sales Comparison Approach
The sales comparison approach is the most common and popular method among investors to evaluate the worth of their chosen property. It requires the investor to examining the sales price of the recently sold properties that are similar to the rental properties within the same neighborhood.
In order to undertake an accurate valuation, you will have to identify 3 to 5 similar properties that can be compared to the property you seek to evaluate. It is important to choose real estate comparisons that have been sold as recently as possible. The goal is to establish the current value of a rental property, and therefore, comparing it with older properties will not provide you an accurate estimate.
The comparison properties must also be located within the same neighborhood and housing market as your chosen property. It is important to note that no two properties are exactly similar, and therefore, you cannot obtain accurate evaluations solely on the basis of sales price. You will have to take into account the differences between the properties and make adjustments to the sales prices. You can use the Mashvisor rental property calculator for accurate valuation results.
Gross Rent Multiplier Approach
The gross rent multiplier approach is based on valuing the rental property on the basis of the rental income it can provide over a period of one year. It comes with a simple formula that is as follows:
Gross Rent Multiplier = Purchase Price / Annual Gross Rental Income
If you obtain a gross rental multiplier of 5, it indicates that the purchase price of the rental property is five times grander than the annual gross rental income it is capable of generating. If you’re examining the value of an investment property for sale, it is ideal to identify properties that have a lower gross rent multiplier, typically between 4 to 7. A lower GRM indicates that the rental property investment will be able to pay off its purchase price in a shorter time duration.
The gross rent multiplier approach provides an easy and simple formula for investors to examine the financial savviness of investing in a renal property. However, this approach also has its won drawbacks. For instance, it does not take into account operating costs and expenses, such as insurance payments, property taxes, maintenance needs, and vacancies.
The gross annual rental income approach does not take into account the expenses of maintaining and purchasing a rental property. It is important to note that each rental property varies from other rental properties in terms of expenses and upkeep. Therefore, this is not the most reliable method and investors need to undertake multiple other calculations for an accurate property valuation.
The income approach is another popular method that allows real estate investors to examine the value of a chosen rental property. It can be used to establish the value of a property by simply dividing it with the net operating income of the property with its capitalization rate.
Here is the formula:
Property Value = Net Operating Income / Capitalization Rate
The capitalization rate is a property metric that is deployed to estimate the return on investment of a chosen property without taking into account the methods of financing. It is typically calculated by dividing the net operating income by the price of the property. Capitalization rates can be taken from real estate comparisons, and they can also be calculating using property calculators and tools.
The income approach allows an easy and quick valuation method that allows investors to examine the true worth of their chosen property.
It is important for an investor to learn the art of valuing a rental property and building a profitable and lucrative investment portfolio. Before entering into negotiations and a purchase agreement, it is crucial to understand the exact value of the property that you are about to purchase.
Instead of focusing on one method, it is ideal to deploy various methods and examining the value of each component to make savvy and beneficial investment decisions. Property valuations are instrumental in understanding the strengths and weaknesses of your chosen investment.