How to Calculate Property Value Based on Rental Income
When buying a property, you must carefully study the investment property. You should be able to understand how the rental property value is computed so as not to end up overspending.
This article will help you understand what an investment property is and how to calculate property value based on rental income. Most importantly, you will learn how a spreadsheet property valuation calculator can easily help determine a property’s gross rental income.
What is an Investment Property?
An investment property is a real estate property that someone buys with the intention of earning from it. An investment property generates income or returns on investment through rental income, future property resale, or both.
There are several investment properties – residential, commercial, and mixed. Any investor who wishes to purchase an investment property conducts studies on how best to gain profit from it before deciding to buy it.
What is Gross and Adjusted Rental Income?
When discussing real estate and property value, you must understand what gross and adjusted rental income are and their importance.
You need to familiarize yourself with these two concepts. The two concepts are essential to calculate property value based on rental income. These two terms are important when dealing with a real estate investor.
Gross Rental Income
Gross rental income is the total amount you receive from your rental property. It is the rental fee your tenants owe you. Gross rental income is the total of all income amounts, including late fees, application fees or down payments, parking fees, pet rent, and CAM reimbursements.
This is a projection of your total income and expenses over time. Understanding gross rental income is crucial, for this helps you make an important decision about whether to pursue the purchase of a property or not. Knowing how to compute this helps you answer whether the property will bring in profit or not.
Adjusted Rental Income
Sometimes, rentable properties are not completely rented (vacancy) and still waiting for new tenants for months or years. When this happens, a vacancy allowance for lost rental income is considered. Hence, you have the adjusted rental income.
4 Methods of Property Valuation
The four methods below help real estate agents and investors determine the potential value of a rentable property. Experts advise using multiple methods when determining the property value to better understand the property’s income-generating potential.
This article will discuss how to compute the property value using the four methods below. Computation can easily be done with the use of spreadsheets. Using Simple Sheet’s property valuation calculator template, you can conveniently compute your real estate property’s cash flow, expenses, and ROI.
- Gross Rent Multiplier Approach (GRM)
GRM valuation method is considered the simplest method of computing the property value. GRM is calculated using the gross rental income without the operating expenses.
The formula for computing GRM is GRM = property value / gross rental income.
For instance, a property has a purchase price of $150,000 and a gross rental income is $15,000. The GRM is 10, meaning it will take 10 years to fully pay your property from the rental income.
A property with a lower GRM is a better investment because you get to pay off the property in a shorter period of time as compared to a property with a higher GRM.
- Income Approach
Also called Cap Rate approach, the income approach uses the income generated by the property to determine the property value. This approach uses two variables – net operating income and the capitalization rate.
The net operating income (NOI) is the property’s income after all gross operating expenses have been deducted. While the capitalization rate is a percentage reflecting the property’s estimated net operating income (market value).
The formula to get the property value using the income approach is Property value = NOI/Cap rate.
The formula for net operating income is NOI = Adjusted gross rental income – Operating expenses.
The formula for capitalization rate is Cap rate = NOI/property value or purchase price.
The operating expenses can be based on the property’s previous expenses or if the property has never been rented before, apply the 50% rule. The goal is to get the property’s value, so you must have the NOI and cap rate figures.
For instance, a property has an adjusted gross rental income of $15,500 with operating expenses of $7,920. Applying the formula for NOI, the result is $7,580.
You don’t need to compute the cap rate if you can quickly get the figure from fellow real estate agents, investors, or property managers. You can use the cap rate of a similar property in the area. For instance, we can assume a cap rate of 5% for the sample computation above.
Applying the formula for property value using the income approach, you get a result of $151,600.
- Sales Comparison Approach (SCA)
The sales comparison approach looks into comparable properties that have recently been sold in the area to determine the property value of the property you are eyeing. This method is also called the price-per-square-foot method.
This approach is best used for residential properties that don’t have rental income (boarding house). Many are familiar with this approach. In SCA, you consider the property’s location and proximity to schools, hospitals, highways, etc. You also consider the property’s features (bedroom, garage, etc.) and condition.
Computing the property value is easy using the SCA. If, for instance, similar properties in the area are sold for $150/sq. ft and the area is 1,000 square feet; the property value is estimated at around $150,000.
This is a simple approach, but the result is not exactly precise. If you want an almost precise computation, you need to compare your property with a property that has the same features as the property you are eyeing and recently sold.
- Cost Method
The cost approach determines the property’s value by comparing the cost of demolishing and rebuilding the property or building a similar structure from the ground up. This approach implies that clients would pursue the option that has a lesser cost.
The formula to obtain the property value using the cost method is Property value = Cost – Depreciation + Land value.
If you are looking at a 1,000 sq. ft property, with a possible re-construction cost of $80,000 and a depreciation rate of 20%. The total depreciation is (80,000 x 0.2 = $16,000). You compare this 1,000 sq. ft property to a similar and recently sold property with a land value of $18, 000.
Plugging the data into the formula, the property value using the cost method is $82,000.
Understanding Rental Yield Results
The rental yield is the income your property generates. There are several types of rental yield and the most common calculation used is the gross rental yield. The gross yield is computed by dividing the annual rental income by the purchase price or market value.
Aside from the gross yield, you need to be able to compute the net rental yield, which also takes into consideration the property’s operating expenses.
It is important to understand rental yield results because achieving a higher rental yield means the property has a high investment potential. Also, understanding rental yield gives them an idea of how long it would take for investors to get the returns on their investment (ROI).
Final Thoughts
Number crunching in real estate can be intimidating and time-consuming. However, you don’t have to stress about it, for you can use an investment calculator to do the math for you.
Spreadsheets can make computation much easier because of pre-made property valuation calculator templates. While using a template can be convenient, seeking professional advice from certified appraisers or real estate agents can also be beneficial if you are eyeing a property to purchase as your source of rental income.
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About the Author
Top Wellington Realtor, Michelle Gibson, wrote: “How to Calculate Property Value Based on Rental Income”
Michelle has been specializing in residential real estate since 2001 throughout Wellington Florida and the surrounding area. Whether you’re looking to buy, sell or rent she will guide you through the entire real estate transaction. If you’re ready to put Michelle’s knowledge and expertise to work for you call or e-mail her today.
Areas of service include Wellington, Lake Worth, Royal Palm Beach, Boynton Beach, West Palm Beach, Loxahatchee, Greenacres, and more.
Michelle Gibson of the Hansen Real Estate Group Inc is a full-time REALTOR who has been specializing in Wellington Florida real estate since 2001. This veteran of the real estate industry has expertise in technology, marketing, and social media.