Due to the increasing revenue from rental properties, income from investment related properties are very high. If you are considering renting your property out or just simply want to invest in property rentals, you need to fully grasp what you are getting yourself and your funds into. So how does one go about on how to value a rental property?
Below are some high-level ways to value rental property:
Sales Comparison Approach
The sales comparison approach (SCA) is one of the most recognizable forms of valuing residential real estate. This approach simply involves the comparison of similar homes that have sold or have been rented over a given time period. Most investors will want to see an SCA over a significant period of time frame to study any potential emerging trends.
The SCA relies on attributes to assign a relative price value. Price per square foot is a common and easy to understand metric that all investors can use to determine how the property should be valued.
Take for example a 2,000 square foot bungalow is renting for N7,500 per square foot, investors can reasonably expect a similar trend in rental income based upon similar rentals in the area.
The SCA is meant to be a baseline or reasonable opinion and not a perfect predictor or valuation tool for real estate as every home has a uniqueness that isn’t always quantifiable. Buyers and sellers have unique tastes and differences.
When requesting for a comparative market analysis, it is important for investors to employ the services of a reputable real estate agent.
2. Capital Asset Pricing Model
This is a more comprehensive valuation tool for real estate. The capital asset pricing model (CAPM) introduces the concepts of risk and opportunity cost as it applies to real estate investing. CAPM looks at the possible return on investment (ROI) derived from rental income and compares it to other investments that have no risk, such as alternative forms of real estate investments such as real estate investment trusts (REITs).
If the expected return on a risk-free or guaranteed investment exceeds the possible ROI from rental income, it simply doesn’t make financial sense to take the risk of rental property.
Without a doubt, all rental properties are not the same. Location and age of property are major considerations. An older rental property would mean landlords will likely incur more maintenance expenses. A property for rent in a high crime area will likely require more safety precautions than a property for rent in a gated community.
The CAPM approach considers the essential risks to rent properties. It suggests factoring in the”risks” before considering your investment or when establishing a rental pricing structure.
All in all, CAPM helps you determine what return you would get for putting your money at risk.
3. Cost Approach
The cost approach to valuing real estate states that a property is only worth what it can reasonably be used for. It is estimated by summing the land value and the depreciated value of any improvements.
Appraisers from this school often maintain the “highest and best” use to summarize the cost approach to property. It is frequently used as a basis to value vacant land.
For example, if you are an apartment developer looking to purchase three acres of land in a barren area to convert into a rental property, the value of that land will be based upon the best use of that land. Let’s say the land is surrounded by oil fields and the nearest person lives 20 miles away, the best use and therefore the highest value of that property is not converting into a rental property, but possibly expanding drilling rights to find more oil.
4. Income Approach
This approach focuses more on what the potential income for rental property yields relative to initial investment. The income approach is used frequently for commercial real estate investing.
The approach relies on determining the annual capitalization rate for an investment. This rate is the projected annual income from the gross rent multiplier divided by the current value of the property. So if an office building costs N140,000 to purchase and the expected monthly income from rentals is N1,400, the expected annual capitalization rate is:
(N1,400 * 12 months) / N140,000 = 12%
This is a very simplified model with few assumptions. More than likely there are interest expenses on the mortgage. Also, future rental income may be less or more valuable five years from now than they are today.
Many investors are familiar with the net present value of money. This concept applied to real estate is also known as a discounted cash flow. Currency received in the future will be subject to inflationary as well as deflationary risk and are presented in discounted terms to account for this.
A rental property can be a profitable endeavor if investors know how to value real property. Most serious investors usually look at components from all of these valuation methods before making any rental decision. Hence, learning these introductory valuation concepts would be a step in the right direction if you are thinking of getting into the real estate investment game and winning
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