How to Calculate The Value of a Rental Property
You’ve got a new rental property and want to make sure you price it at market value. The only problem: you don’t know how!
In truth, there are multiple ways to calculate your rental property value. Different ways may be different for certain properties or rental markets. You can also use some of these ways to determine whether a new rental purchase will be worth the investment.
5 ways to calculate your rental property’s value.
Capital Asset Pricing
The first method is also the most accurate. The capital asset pricing model, or CAPM, helps you evaluate potential rental income by including both opportunity cost and rental risk. Specifically, it examines return on investment or ROI you get from the cash flow of total annual rent income. Then it compares it against investments without risk, such as US Treasury bonds or real estate investment trusts/REITs.
If your ROI on a risk-free investment is higher than your potential rental property ROI, the rental property isn’t a wise investment at all.
To calculate CAPM:
Take the projected return on investment for your hypothetical rental property or for how much you plan to charge for renting your units
Then, compare it to the projected return on investment for US Treasury bonds
If the treasury bond investment return on investment is higher, don’t buy the rental property or, alternatively, increase your rental rates so you earn a higher ROI
Sales Comparison Approach
The sales comparison approach, or SCA, means you compare similar properties that were sold or rented in your local area over a set timeframe. It basically means comparing your rental property against other properties, then using that information to price your rental property appropriately.
Keep in mind that this approach only provides you with a ballpark estimate. It doesn’t offer specific price points for your rental property and doesn’t take into account any special features your property might include, such as a pool, in-unit laundry, etc.
Use listing websites or services, like Zillow, to learn the rental prices for units near your new rental property. You can then price your property the same or higher or lower depending on your personal valuation for its features.
If you’re using the sales comparison approach, reach out to our team to learn more about local comps and we can help you set a fair rental price.
Income Approach
The income approach is oftentimes used for commercial real estate investing. It examines the rental property’s potential income cash flow and compares it to your initial rental property investment price. It uses the cap rate, also called the annual capitalization rate for the investment property.
To calculate the cap rate:
Take your net operating income, or NOI
To calculate the NOI, find your property’s net rental income (gross income – annual expenses, including operating costs)
Then divide the net operating income by the value of your property
Once you get this number, you’ll see the true income you’ll receive from the property at a projected rental rate. Then you can adjust your rental rate higher or lower depending on how much money you need to make, how much you think is fair, etc.
Here’s an example of the income approach in action:
Say that you have a new building that cost $120,000
The net operating income is $1200
To calculate your cap rate, you’d use the following equation – $14,400 (or $1200 x 12 months) / $120,000
The result is 0.12 or 12%, which is your cap rate
You can use this approach to determine whether the purchase price/down payment for a new property is worthwhile overall. It may also tell you whether an interest rate is appropriate for the property in question.
Cost Approach
The cost approach simply means determining whether a real estate asset is worth what it may be reasonably used for. To calculate the cost approach:
Add up the cost of land and the cost of construction, then subtract depreciation
Add any other costs or improvements you need to make
Then examine the potential income you may receive from the rental property based on how much you plan to rent your unit(s) for
This rental price should return on your investment at a rate that you’re comfortable with
In this way, you can calculate your rental property value by estimating how much it would cost to build the building from scratch.
Gross Rent Multiplier
Last is the gross rent multiplier approach. The gross rent multiplier approach has you estimate your rental property’s value based on how much rent you can reasonably collect each year. This takes other costs, such as utilities, vacancy rate, insurance, and operating expenses for granted.
To calculate the gross rent multiplier, you have to take your property’s value, then divide it by your gross rental income for 12 months. Here’s an example:
Say you purchased a property for $500,000. The property’s projected rental income is $90,000
The equation looks like this – $500,000 / $90,000 = 5.56
The 5.56 tells you how long it will take for you to pay off your property, or about 5 ½ years. The GRM is a very useful tool since it helps you estimate your rental property’s fair market value and whether it’s worth investing in as a rental property owner.
Which Calculation Should You Perform?
In the end, each of these calculations can be useful when estimating your rental property’s value. However, the GRN and CAPM are the two best ways to very accurately calculate your rental property value without relying on estimation.
However, the other methods, including the sales comparison approach, can be helpful when trying to determine the value of the property and how much you should charge rent to your tenants. In this way, you can ensure that you earn enough money from your rental property to make your investment worthwhile.
Don’t forget there are plenty of rental property calculators online, too. These often incorporate the above approaches by taking multiple metrics into account, including:
Property taxes
Closing costs
Mortgage payments and mortgage rate
Loan term and loan amount
HOA fees
Cost for renovations
Monthly cash flow/monthly income
Rate of return
Property management fees
Annual income
Maintenance costs and repair costs
Be sure to tally up all of your rental management costs as you calculate property value. For example, if you hire a property management company, that will eat into your bottom line and increase how much you need to charge to turn a profit.