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Proven ways to value a rental property

PMI Richmond - Thursday, July 22, 2021
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Richmond property management companies are reporting that real estate is approaching or surpassing all-time record-setting values here locally. Homeowners are thrilled with the increased equity they are accruing on a monthly basis. Investors are also flocking to the area, in an attempt to make the most of the hot market that we are currently experiencing.

Not only are most property values on the rise, but also the rent you can charge for a property is steadily climbing too. Despite all of these positive indicators, something that should be kept in mind is that there are still plenty of overpriced assets on the market that investors need to watch out for.

Without proper valuations prior to purchasing a property, an individual investor can significantly impair their portfolio going forward. In this blog post, we are going to discuss a few methods that can be utilized to ensure that a property is valued accurately.

The income approach

The income approach determines the valuation of an asset by computing the annual capitalization rate. This number is calculated by taking the annual projected income that a property should generate, and dividing it by the current value of the property in question. 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%.

As a rule of thumb, a property with anywhere between an 8-12% cap rate is considered a solid investment. However, it’s important to remember that the higher the demand in the area, the lower the cap rate will be. Popular metropolitan areas like Richmond can yield a cap rate of closer to 4-7% and still be considered a decent value.

The income approach is in all reality a fairly simplified model, and as such, it’s important to take into consideration things like mortgage interest expense to ensure your valuation is thorough enough to ensure the purchase is a prudent one.

The sales comparison approach

The sales comparison approach is probably the most frequently used valuation model in residential real estate. Both real estate agents and real estate appraisers alike tend to use this method on virtually every transaction that they are involved in. This approach is based on similar pieces of property in the local geographic area that have been recently rented out or sold.

It is common for potential investors to request to see the sales comparison approach factored out for a few years time. This allows them to analyze any positive or negative trends that may be happening in the local market.

This method relies heavily on comparing apples to apple-type assets. Things like square footage, number of bedrooms, and lot size factor in heavily when making comparisons. The vast majority of appraisers and real estate agents calculate a price per square foot as a basis for their comparisons on properties they are dealing with. Once you have that number, it’s reasonable to expect similar value in similar properties in the same general locale.

Gross rent multiplier

At its core, GRM is based on accurately forecasting the amount of rent that a property owner can expect to collect annually from a specific property. This number is calculated before things like utilities, taxes, and insurance expenses are factored in. This method is actually very similar to the income approach, but it doesn’t use a capitalization rate. Alternatively, GRM isolates the gross rent expected and focuses the attention on that value.

To figure out the gross rent multiplier, you simply divide the cost of the asset by the annual rent that you expect to collect from the property. 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. With this method, the lower the number comes in, the better the investment. A favorable range is typically somewhere between 4 to 7, but it is important to remember that just because the number is higher than 7 doesn’t necessarily mean the property is a bad investment. It simply means that the asset under consideration might take longer to pay for itself than an asset with a lower GRM.

These are a few of the most widely utilized and accepted 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 Richmond with any southside property questions or inquiries about properties in any of the counties surrounding Richmond VA.