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Proven ways to value a rental property

PMI Contra Costa - Sunday, July 11, 2021
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In California, real estate is fast approaching and/or surpassing record-setting valuation. Current property owners are reaping the benefits of the increased equity they are achieving. Investors are flocking to the market as well looking to profit from the current climate. As prices climb, more and more people are looking for Walnut Creek houses for rent, which makes owning a rental property in the area a smart investment.

Property values are not only climbing, but the rent you can charge is also climbing at a reasonably steady pace. However, you still need to be prudent and watch out for overpriced assets on the market. Without proper valuations prior to purchasing a property, a real estate investor can significantly impair their portfolio.

In this blog post, we’re going to go over a few methods that are commonly used to make certain you are properly valuing a property prior to purchasing the asset.

The income approach

The income approach is used to determine an asset’s value by figuring out the annual capitalization rate. This number is calculated by taking the annual projected income and dividing it by the current value of the property in question. For example, if a rental property costs $200,000 to purchase, and the annual rent collected is $18,000 ($1,500 per month x 12 months) then the annual capitalization rate would be 9%.

In the majority of geographic areas, an asset with anywhere between an 8-12% cap rate is considered a good option. However, it’s important to remember that the higher the demand in the area, the lower the cap rate will be. Desirable metropolitan areas like San Francisco and Oakland can yield a cap rate of closer to 4%, yet still be considered a solid investment. The income approach is a relatively simplistic model, so it’s important to take potential additional expenses like mortgage interest into consideration to ensure your valuation is accurate.

The sales comparison approach

The sales comparison approach is the most widely utilized valuation model for residential real estate transactions. Both real estate agents and real estate appraisers use this method. The approach is based on having similar properties in the local geographic area that have been recently sold or rented out.

When looking to purchase an investment property, potential investors like to see the sales comparison approach factored out over a few years, so that 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. Once you’ve determined what that number is, it’s reasonable to expect a similar value in similar properties nearby.

Gross rent multiplier

GRM is based on estimating the amount of rent that a property owner can reasonably expect to obtain from the asset on an annual basis. This number is calculated before utilities, taxes, and insurance expenses are taken into account. This method is quite similar to the income approach but doesn’t use a capitalization rate. This method isolates the gross rents that are reasonably expected.

To calculate the gross rent multiplier, simply divide the cost of the asset by the rent you expect to collect every year. For example, if a property is priced at $450,000 and you think you will receive $36,000 in annual rent ($3000 per month) the gross rent multiplier would be equal to 12.5. The lower the figure, the better. A good range to look for is typically somewhere between 4 to 7. However, if the GRM is higher it doesn’t necessarily mean it’s a bad investment. It just means that the asset might take a while longer to pay for itself.

These are a few of the standard methods used to properly evaluate 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 Contra Costa with any property management Walnut Creek California questions or inquiries.