How to Value a Rental Property
In this guide I’ll share tips on how to analyze and value a potential property if you’re considering getting into the rental property business.
There are different types of rental properties from single family homes to multi-family (apartment complexes, duplexes, triplexes).
Depending on the type of rental property, it may be valued differently. For example, single family rental property uses sales comps while apartment complexes use net income and cap rates to value them.
We will start by analyzing a traditional single family home as a potential rental property and how to determine the value of the rental property to help you make a good offer at a reasonable purchase price.
Valuing a Single Family Rental Property
A single family home is a home that stands alone as its own property. You have a yard and property lines dividing this home from other homes next to it.
A single family home is a standard home type that is found in most subdivisions.
To determine the value of the single family home as a rental property, you need to look at sales comps. This is real estate data on other homes in the neighborhood that are similar to your potential investment property.
For example, if you’re targeting a 3 bed, 2 bath home with around 1,600 square feet of living space, then you’ll want to narrow down the sales comps to other homes that are 3 bed, 2 bath and have close to 1,600 square feet of space.
I usually go 200 square feet above and below my property’s square footage. In this example case, you’d target homes that are 1,400 to 1,800 square feet.
When we look at the sales data, we want to see what the listing price was and the final sales price when the home sold.
Additionally, we want to look at the condition of the home to determine if it sold at maximum value and was in tip top shape or if the home seems to have sold at a discounted price due to being in distressed condition and in need of repairs.
This gives insight to compare against your investment property to discount any differences in condition between your investment property and the sales comp home that already sold.
Essentially, we use data of homes that are similar to see what our property could sell for since these homes have already tested the market and got buyers to offer a specific price range for the similar features that our potential investment home has.
Let’s say for example, after pulling sales comps for the 3 bed 2 bath, 1,600 SF home, that we find the following sales data:
- Home 1 sold for – $180,000
- Home 2 sold for – $200,000
- Home 3 sold for – $205,000
This gives us an idea that the potential worth of our single family rental property could be around the $200,000 range if it’s in good condition like the homes that sold for $200,000 and $205,000.
Overall, single family rental property is valued using the sales comparables method where you look at other homes in the neighborhood and determine the value based on the past sales history of that neighborhood’s homes.
It doesn’t matter if they were rental properties or just average homes a family lived in. They’re all the same type of property so sales comps can be used to compare them apples to apples.
Condition of the property will be the biggest adjuster to the price to discount for any repairs a property needed and tells the story of why it sold cheaper or more expensive relative to other homes.
Valuing Multi-Family Rental Property
Multi-family properties are those that have multiple units sharing the same piece of land. For example, an apartment complex would be a large building on a piece of land that houses several rental units on the same property.
As we get into multi-family rental properties, the valuation method changes from sales comparables to an income based approach.
We want to compare the income, expenses, and net profit of a multi-family property with that of other multi-family properties that recently sold to see how investors valued the net income of the property.
If two properties both have a similar net income of $25,000, then you’d expect the purchase prices to be pretty similar between these two properties if all other things are pretty equal.
In the world of stock investing, investors use the P/E ratio, analyzing the price of the asset relative to it’s earnings to come up with a multiple known as the P/E ration.
Taking this to real estate investing in the multi-family space, if you have a property that had net income of $25,000 and a purchase price of $250,000 then the P/E ratio is 10. The investor paid 10 times the earnings of the property.
In real estate investing, we look at this ratio inversely as a percentage and call it the “cap rate”.
Cap rate is taking the net income and dividing it by the purchase price to get the percent return on investment.
For example, the $25,000 net income divided by the $250,000 purchase price would give a 10% return on investment. The cap rate of this property is therefore 10%.
We can now compare properties to each other by looking at their respective cap rates. If two similar properties sell at vastly different cap rates, then there is some reason that investors paid a premium for the one property and a discount for the other.
This could be location related or it could be the condition of the property that vastly differed.
Future value of rents
When valuing multi-family rental properties, it’s also important to analyze the future potential of the property.
If rents are below market value currently, then you can adjust them in your analysis to determine a new estimated gross rent and net income based on the future value of increasing the current rents higher.
This helps add value to the property. As the net income increases, you can sell the property for a higher purchase price if you’re using the same cap rate.
For example, if you plan to sell a property at a 10% cap rate:
- $25,000 net income = $250,000 sale price
- $40,000 net income = $400,000 sale price
- $55,000 net income = $550,000 sale price
So if you can find ways to increase rents and reduce expenses, you can increase the net income and thus increase the value of the property. This is how investors buy multi-family properties, fix them up, and resell them for more money.
Overall, multi-family rental property values are based on cap rates which is dependent on the income of the property, unlike single family homes which rely on the sales prices of similar single family homes in a subdivision and don’t use income.
Thanks for reading today’s tips on rental property valuation methods.
Nick Foy, Founder of Under30wealth.com
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