In many areas of the country, real estate is approaching or surpassing all-time record-setting values. Current homeowners are basking in the increased equity they seem to be generating by the thousands. Investors are swooping in to make the most of the hot market as well. Not only are property values climbing, but the rent you can charge is steadily climbing as well. However, there are still plenty of overpriced assets on the market. Without proper valuations prior to purchasing a property, a real estate investor can torpedo their portfolio before it even gets off the ground. In this blog post, we’re going to go over a few methods that can be utilized to ensure you are properly valuing a property prior to making the investment.
The income approach
The income approach calculates an asset’s value by determining the annual capitalization rate. This figure is calculated by taking the annual projected income and dividing it by the current value of the property. For example, if a rental property costs $200,000 to acquire, and the annual rent collected is $18,000 ($1,500 per month x 12 months) the annual capitalization rate would be 9%.
Generally speaking, a property with anywhere between an 8-12% cap rate is considered a good investment. The higher the demand in the area, the lower the cap rate will be. Popular metro areas like New York City and Los Angeles can yield a cap rate of closer to 4% and still be considered a solid investment. The income approach is a fairly simplified model, and it’s important to take into consideration things like mortgage interest expense to ensure your valuation is accurate.
The sales comparison approach
The sales comparison approach is one of the most widely recognized valuation models for residential real estate. Both real estate agents and real estate appraisers tend to utilize this method most frequently. This approach is based on similar properties in the geographic area that have been sold or rented out in the recent past.
Often, potential investors like to see the sales comparison approach factored out for a few years, so they can analyze any positive or negative trends that may be occurring. This method relies heavily on comparing apples to apples. Things like square footage, number of bedrooms, and lot size factor in heavily when making comparisons. Many appraisers and real estate agents calculate a price per square foot as a basis for their comparisons. Once you have that number, it’s reasonable to expect similar value in similar properties in the same geographic area.
Gross rent multiplier
This method is based on ascertaining the amount of rent that an investor can expect to obtain from the asset annually. This number is calculated before utilities, taxes, and insurance expenses are factored in. This method is similar to the income approach, but it doesn’t use a capitalization rate. Instead, this method isolates the gross rent expected and focuses attention on that number.
To calculate the gross rent multiplier, simply divide the cost of the asset by the annual rent you expect to collect. For example, if a property is priced at $450,000 and you expect to collect $36,000 in annual rent ($3000 per month) the gross rent multiplier would be equal to 12.5. When it comes to GRM, the lower the figure, the better. A good range is typically somewhere between 4 to 7, but just because the number is higher doesn’t necessarily mean it’s a bad investment. It simply means that the asset might take longer to pay for itself than one with a lower gross rent multiplier.
These are a few of the standard methods used in properly evaluating the worth of real estate. Be sure to look for a future blog post where we will continue the discussion. As always, please contact PMI Green Rock with any seacoast rental questions or inquiries.