Property valuation is the process of determining the economic value of a real estate investment. It seeks to estimate the fair market value of the real estate property, i.e., the price at which a sufficiently informed seller and adequately informed buyer would agree to transact.
Therefore, to value a real estate rental property means you need to determine the price at which the seller and buyer, both possessing sufficient information, will transact a rental property sale/purchase without remorse.
It’s important to remember that the property’s price doesn’t always equate to the value. For instance, a distressed seller might accept a price below market value. Excited buyers may also pay above fair value to close the deal quickly.
Importance of Property Valuation
Property valuation is critical for many reasons. In fact, it’s important to many other entities other than the seller and buyer.
First, property valuation is the main factor in determining property taxes at the IRS. Without proper valuation, it would be impossible to determine the fair tax rate for different properties.
Additionally, home mortgage lenders rely primarily on property values from the home appraisal process to determine how much money to give the borrower. Accurate valuation data protect the lender from “spending” too much on a property that’s worth way less.
Finally, home valuations are also critical in settling legal matters such as divorce, real estate settlements, and lawsuits.
Ways to Value a Rental Real Estate Property
There are several ways to value a rental real estate property. However, most people use five main approaches;
- Sales comparison method
The sales comparison approach (SCA) is one of the simplest and most popular ways to value real estate properties. It’s also the method most used by appraisers and real estate agents when evaluating real estate rental properties.
SCA involves comparing similar homes sold or rented in the same location over a specified period. It relies on features and attributes to assign relative price value. These attributes may be based on specific features, such as the number of bedrooms and bathrooms. Pools, decks, and garages are also usually considered.
- The income method
Another popular property valuation method is the income approach. The income approach looks at your property’s potential income cash flow relative to the initial investment. It relies primarily on the annual capitalization rate of the property, also known as the cap rate.
The annual capitalization rate (cap rate) is the projected net operating income (NOI), i.e., the property’s net rental income (gross income minus expenses), divided by the current asset value. The cap rate can also be invaluable when comparing several property values.
- The cost approach
The cost approach assumes that an asset is only as valuable as its use. Thus, it calculates the value of the property based on the cost of land and the cost of constructing the property, minus the depreciation of the property. As a result, the approach works best for new properties.
The other way to think of it – how much would it cost to build the property from scratch today? The answer to this question is the actual value of the property. It doesn’t make sense to buy a property for more than it’s worth, right?
- The gross rent multiplier approach
This is also a straightforward method. Essentially, you approximate the value of the property based on the projected rental income over a year. The total rental income is a net value, meaning that you subtract taxes, operating expenses, insurance, and utilities from the gross income. The final figure must also be adjusted for vacancy rate and other critical factors.
The property’s value is then divided by the gross rental income for the year to determine the gross rent multiplier (GRM). For instance, if the property is valued at $1 million and the projected annual rental income is $80,000, then the GRM is 1,000,000/80,000 = 12.5.
- The capital asset pricing method
Finally, the capital asset pricing model (CPAM) is the most accurate way to value a real estate rental property. It looks at the return on investment derived from cash flow from the total annual rent and juxtaposes it with investments with zero risk. For instance, the evaluator can compare the returns to US Treasury bonds or real estate investment trusts.
The biggest advantage of CAPM valuations is that they consider the risk. The approach is also more granular as it considers fundamental differences between properties, such as location and age.
Rental property valuations can be critical when buying (or selling) the property. It’s also critical for IRS taxation purposes and in legal settlements. So, it’s better not to skimp on it.