How do you determine the value of an investment property? What's the best way to go about analyzing the value of a rental property? Some investors like to use the rent roll, others the value of property itself.
Whether you call it an income property or rental property, what's the method you use to determine if it's a good buy? And how do you figure out what the current value of the property is?
Base your analysis on the actual numbers and not future numbers of the investment property you're analyzing. Ask for a rent roll and operating expenses report from the current owner of the property. Then, cross check this information with the actual leases for the units. Delve into the information that the owner of the rental property gives you and make comparisons with other properties, insurance rates, property taxes, service and repair companies, property management costs and so on.
If this is a property that you're converting to an investment property then you can base your analysis on what similar properties in the area are renting for.
- Cost Per Unit – compare the cost of each unit in an apartment complex or building
- Square Footage – cost of property divided by square footage (not all space is created equal, square footage of an attic is not the same as a basement or a garage let’s say)
- Gross Rent Multipliers – cost of property divided by cash flow from rent minus expenses (if you have a rent roll you can use the formula to gauge the value of the property)
- Opportunities For More Value (conversion or additions; parking, laundry services, and other amenities)
TIP: Is this an area that is already overrun with investors? Seek out a market that's not saturated with investors. Locals know best. As you grow your network, friends in communities and cities around the United States will become a key aspect of your research, alerting you to new properties and changes in communities. Local newspapers and agents can also facilitate your research. For example, local papers will tell you if there's a new development in the works right near where you want to buy property.
The biggest change of late is the usefulness of the Internet in doing research, and especially in real estate. Now, it's more of a level playing field, real estate agents don't hold all the cards. You as the investor, can do more research on your own.
Formulas to Determine Value:
Capitalization Rate = net operating income / purchase price.
Net operating income – deduct expenses from income (total rents, parking, laundry…)
So if an apartment complex costs $400,000 and earns a Net income of $50,000, then the equation is: $50,000/$400,000= 12.5%
True Property Value = total operating income / capitalization rate.
So we take the net operating income of $50,000 and divide that by the capitalization rate of 12.5%, the equation is: $50,000/12.5=$400,000
Gross Rent Multiplier - GRM
Property value divided by the gross income = GRM (Gross Rent Multiplier)
So if the total cost of the property was sold for $600,000 and the gross income is $75,000, the equation is: $600,000/$75,000= GRM of 8
The formula is used to determine market value of a property, to gauge what a property should be listed for. Use this formula, the gross rent multiplier x annual income of the property, to get a price for the property. For instance, the GRM is 8 and the income is $57,000. The equation is: 8 x $57,000=$456,000
House P/E Ratio= House price /rent (market rent) - expenses
How much are you making, what is your cash flow? Subtract the net operating income by the loan payment.
Determine percentage of profit you’ve made on a sale of a property:
Property sold for $300,000; originally you bought the property for $225,000. Divide the profit by the purchase price. The equation is: $75,000/$225,000=.33 or 33% profit.
Return on Invesmtent (ROI)
It’s good idea to gauge how your investment is doing once a year. Determine if it’s worth keeping or selling or figuring out ways to gain more value from the property. The return divided by the investment and times 100 gives you a rough ROI.
Return (rental income) / Investment x 100 = ROI
Say you bought a house for 150,000 in cash and earn $8,000 in rent each year, your ROI formula would be:
$8,000 / $150,000 x 100 = 5.3% (That’s your return each year).
TIP: When looking a comparable home sales, remember that if the real estate market is change rapidly, then there's a delay for some of the sale numbers since it takes time for the sales to actually close and get recorded. So homes could have sold for less three weeks ago than they are selling for today or vice versa--homes selling for more. Just something to consider if the market is influx and changing at a rapid rate.
There are also seasonal differences in real estate prices, as the real estate market slows a bit in areas where winter months are colder and there's a lot of snow. Plus, most people aren't going to be moving or selling their property during the winter months. Usually spring and summer are times when properties are sold as its easier to get their kids out of school.
Rent Roll: What is a rent roll? A rent roll is just the number of tenants in a property and what they're paying in rent. If you don't have an actual rent roll from the property, a current rent roll, then you can estimate what you could make in rent for each unit based upon what similar units in the area are renting for.
Remember though, each tenant has an agreement that they sign each year, so you have to factor in who is going to renew their lease or who may move. Also, is their rent control in the area where you are buying? If so, there are limits to how much you can raise the rent for a unit.