How To Calculate Property Value Based On Rental Income
Valuating a property based on rental income is the most accurate way to determine its true worth. Taking the time to assess properties this way helps ensure that you’re paying fair market value as a buyer—or that you’re getting full asset value as a seller. There are several different ways to calculate property value based on rental income. Here are a few of the top methods:
Sales Comparison
Arguably the most common approach used in real estate investing, this method involves matching up “comparable” properties that have sold within the last 3 months. Comparables are those with similar construction dates, features, square footage, upgrades, amenities, geographic location, and other factors. The more alike the properties are, the more accurate the comparison will be. Although this is a simple approach, the wide range of potential differences makes it somewhat unreliable. To achieve the closest comparables, it’s recommended to compare the properties you’re interested in with several others in the area.
When comparing rental properties, it’s essential to consider the operating expenses and gross rental income. For example, if you’re reviewing multifamily properties with income-generating rental suites, you would look at how much each unit is renting for, how many vacancies there are, and the total overall cost to keep the building operational—such as utilities, maintenance, insurance, municipal service fees, and property taxes. These details will help you assess whether the purchase will deliver a profitable return on investment (ROI).
Gross Rent Multiplier (GRM)
The GRM of a property is a fairly simple way to measure the value of a rental property. There’s a bit of math involved, but it’s a straightforward way to determine approximate values. The major difference between this method and others is that it only takes into account the estimated annual rental revenue of the property—and none of the operating expenses.
For example, a multifamily rental property in the Cowichan Valley has a list price of $1,000,000. From the 6 rental units in the building, the annual rental income would be $144,000 ($2000 x 6 = $12,000 per month x 12 months = $144,000). To determine the GRM, divide the list price by the annual rental income ($1,000,000 / $144,000 = 6.94 GRM).
This calculation estimates that, as long as the annual rental income stays consistent, the rental property will earn back the initial $1,000,000 investment in 6.94 years. When you’re comparing the GRM to other properties, a lower number is typically a better choice because you can discharge the liability more quickly, resulting in a better ROI.
The GRM can also be useful when reviewing comparables. Rental property values can be estimated by assuming that similar properties in the area have the same GRM. So if a comparable building has a gross annual rental income of $125,000 and the GRM is 6.94, the property should have an estimated value of $867,500. These calculations can help you determine whether a property has been overvalued, falls within the median, or if it’s undervalued and a prime investment opportunity.
Income Approach
This method of valuation is based on the net operating income (NOI) and capitalization rate (cap rate) of the property. The NOI is determined by subtracting operating expenses from the gross annual rental income. The cap rate is assessed by dividing the NOI by the property’s list price.
For example, the Cowichan Valley rental property has an annual gross rental income of $144,000. The annual operating expenses for the property are estimated at $60,000 per year. The NOI for that property would be $84,000 ($144,000 – $60,000).
To find the cap rate, divide the NOI by the property value. On the $1,000,000 property, the cap rate would be 8.4% ($84,000 / $1,000,000). This formula can then be used to determine the value of other comparables.
For example, if a rental property has a $100,000 NOI, multiplying the NOI with the cap rate would give you an approximate valuation of $840,000 ($100,000 x 8.4).
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