The Landlords Guide: Rental Property Valuation
There are several methods to value rental property and also a few different factors/metrics you need to keep in mind when trying to put a value on a property. A few of the methods are: the Sales Comparison Approach (commonly used for single family houses), the Capital Asset Pricing Model, the Income Approach, and the Cost Approach.
You can look up the others, but the one we think is the best and most commonly used is the Income Approach so we will be focusing on that. Before we get into this approach, here are a few definitions and formulas to understand:
Net Operating Income (NOI) = (Yearly Income of Property) - (Yearly Expenses of Property)
*Yearly expenses don’t include the mortgage when determining NOI
Capitalization Rate (Cap Rate) = NOI / (Initial Cost of Property*)
*This usually means the purchase price, closing costs paid, and major improvements needed for the property. Your all-in cost on day one. Some investors only consider the purchase price but this isn’t completely accurate.
Cash Flow = NOI - Mortgage Payments
*If there is no mortgage on the property, your cash flow will equal the NOI
Cash on Cash Return = (Cash Flow) / (Cash Invested in the Property*)
*This includes only the money you personally have invested which is any out-of-pocket items like the down payment, remodeling costs, or any other initial costs. This does not include mortgages or other loans that didn’t come from you. This will equal Cap Rate if you pay 100% cash for everything. There is also a modified formula that includes equity in the property in the calculation but we won’t get that detailed.
These are the most common metrics with a rental property and investors use these to determine if a property is worth investing in. Although, people also consider appreciation, tax benefits, and building equity / loan paydown when investing. For pretty much all investors, cash flow is going to be the main thing they are investing for. For people paying cash, the NOI and Cap Rate are going to be more important most likely. For people using financing, Cash Flow and Cash on Cash Return will be more important. Either way, investors normally have some sort of criteria that they need to reach that will make it a good investment for them. It also depends on what market you are in. For an investor to invest in a C-class property in Ohio, they will most likely want higher returns than an investor looking at property in an A-class neighborhood in San Diego for various reasons.
The Income Approach is your NOI formula while using the other formulas and your standards to determine whether an investment is worth pursuing. It is straightforward and is an easy way to figure out the value of the property. The math is pretty simple but it may be more difficult to get accurate information regarding the income and expenses so it is important to always do due diligence when looking at an investment property. The condition of the property and vacancy rates need to be considered as well before investing. Here is an example of the income approach broken down into more detail:
A duplex at 123 Main Street:
Income: $1,200/month or $14,400/year (each unit rents for $600/month)
Utilities that owner pays: $100
Maintenance and Capital Expenditures: $144 (12% of rents set aside)
Vacancy: $120 (10% of rent set aside)
Property Management: $120
So the monthly NOI would equal: $1,200 - $804 = $396
The yearly NOI = $396 * 12 = $4,752
If an investor’s Cap Rate standard is 10%, then they would value the property at:
$4,752 / (10% or .10) = $47,520 = Initial Cost of Property
If their standard is a 9% Cap Rate, then the value would be $52,800. Again, the Cap Rate depends on a mix of the market you are in and your personal standard.
Going further, you can use the other formulas to determine the other metrics if you add financing to the mix. Sometimes, metrics can be a little flexible if other portions of the investment are attractive. For example, a great Cash on Cash Return may override a lower Cap Rate. Or, good financing terms may allow you to accept a little less cash flow. Valuation and determining whether an investment is good is as much an art as a science in structuring a deal with a buyer or seller and also hinges upon an investor’s personal criteria.
This was just the basics of using the Income Approach to value property but it really isn’t rocket science. If you own investment property yourself, knowing these financials on your property is very important. We hoped you learned something or at least brushed up on this info. It was a short article so if you have any questions or need more info on any of this, feel free to reach out to us and we would be happy to help!