Investing in real estate? How to Value Rental Property

2. Gross rent multiplier (GRM) approach

The gross rent multiplier (GRM) approach is a method for valuing rental properties based on their potential rental income. The GRM is determined by dividing the property’s price by its annual gross rental income. This method provides a rough estimate of the property’s value.

Using the GRM approach, investors can estimate the number of years it might take for the property’s gross rental income to finally pay for itself. A lower GRM indicates a better investment opportunity because it suggests a higher rental income relative to the property’s price. This option should be considered an initial screening tool because you’ll also need to account for expenses like taxes, insurance, utilities, and maintenance costs.

Gross rent multiplier approach example scenario

Suppose you’re evaluating a rental property priced at $450,000, with an annual gross rental income of $60,000. To calculate the GRM, divide the property’s price by the annual rental income:

Property Value / Annual Gross Rental Income = GRM

$450,000 / $60,000 = 7.5

Next, compare this GRM with the GRMs of similar properties in the area. If comparable properties have GRMs of around 8 or higher, the property you’re considering may be a good investment. Conversely, if other properties have significantly lower GRMs, you might want to reconsider or negotiate a lower purchase price.

3. Income approach

The income approach values rental properties based on their ability to generate income, making it a favored method among investors focused on cash flow. This approach evaluates a property’s net operating income (NOI) and the capitalization rate (cap rate) to estimate its value. The NOI is the annual income from the property after subtracting operating expenses, while the cap rate represents the expected rate of return on the investment.

This method is particularly useful for properties with stable and predictable income streams, such as apartment buildings or commercial real estate. The income approach allows investors to compare properties by evaluating their potential returns, helping them make informed decisions about where to invest their money.

Income approach example scenario

Consider you’re evaluating a rental property with an annual net operating income of $16,800 ($1,400 expected monthly income x 12). The property’s market value is $140,000.

NOI of $16,800 / $140,000 = 0.12 or 12%

In the local market, similar properties at the same price have a capitalization rate of only 10%.

NOI of $14,000 / $140,000 = 0.1 or 10%

This approach provides you with a clearer picture of the property’s income-generating potential relative to its value. In this example, the first property may be a worthwhile investment.

How Much Is Your Home Worth Now?

Home values have rapidly increased in recent years. How much is your current home worth now? Get a ballpark estimate from HomeLight’s free Home Value Estimator.

Get Estimate

4. Cost approach

The cost approach estimates a property’s value based on the cost to replace or reproduce it. In other words, using a hypothetical pretense of total destruction, this method answers the question, “How much would it cost to rebuild the entire property from the ground up?” It assumes that a property’s value is equal to the cost of constructing a similar building at current prices, plus the value of the land, minus any depreciation.

This method is most effective when applied to properties with recent construction or significant improvements, as it relies on current construction costs and depreciation estimates. For older properties, depreciation can be more challenging to calculate accurately, making the cost approach less reliable. However, it remains a valuable tool for appraising special-use properties, such as schools, churches, or public buildings, where comparable sales are scarce.

Cost approach example scenario

Suppose you’re evaluating a newly built rental property. The land is valued at $100,000, and the construction cost of the building is $350,000. If the building has not depreciated, the property’s value is the sum of the land and construction costs:

Property Value = Land Value + Construction Cost

$100,000 + $350,000 = $450,000

If the building has depreciated by $50,000, the adjusted value would be:

Adjusted Property Value = Property Value – Depreciation

$450,000 – $50,000 = $400,000

The cost approach strives to provide a realistic estimate of a property’s value based on its replacement cost, helping investors assess whether the property is priced appropriately relative to its current condition and potential use.

5. Other options: From complex to automated

In addition to the traditional valuation methods, there are other options that can provide investors with deeper insights or quicker estimates. Two such methods are the capital asset pricing model (CAPM) and rental property calculators.

Capital asset pricing model (CAPM)

The capital asset pricing model (CAPM) is a more complex method used to determine the expected return on an investment property. This approach takes into account the risk-free rate of return, the expected market return, and the property’s beta (a measure of its volatility compared to the market). CAPM is useful for investors who want to assess the potential return on investment relative to the risk involved.

For example, if the risk-free rate is 2%, the expected market return is 8%, and the property’s beta is 1.2, the expected return can be calculated as follows:

Expected Return = Risk-Free Rate + Beta * (Market Return – Risk-Free Rate)

Expected Return = 2% + 1.2 * (8% – 2%) = 9.2%

This approach can help investors evaluate whether a property offers a return that justifies its risk compared to other investment opportunities.

Rental property calculators

Rental property calculators are automated tools that can quickly estimate a property’s value and potential return based on inputted data. These calculators typically require information such as purchase price, rental income, expenses, loan details, and vacancy rates. By inputting these details, investors can get an instant snapshot of a property’s financial performance.

For instance, an online rental property calculator might ask for:

• Purchase price: $400,000
• Down payment amount: $80,000
• Monthly rental income: $2,400
• Insurance: $1,200 annually
• Property tax rate: 1%
• Appreciation rate: 2.5
• Other expenses: $220 a month
• Loan details: $320,000 loan with 6.8% interest

The calculator will then provide metrics like cash flow, cap rate, and ROI, helping investors quickly assess whether a property meets their investment criteria.

Examples of rental property calculators

• Calculator.net Rental Property Calculator
• Zillow Rental Property Calculator
• Avail Rental Property Calculator
• TurboTenant Rental Property Calculator
• Calculator Academy Rent To Value Calculator
• Fit Small Business Rental Property Calculator

Find a good rental property with a top agent

Many first-time investors will take a low-risk step into the investment pool by buying a second home and renting their first.

If you’re looking to purchase a rental property with a favorable ROI, the right real estate agent can provide valuable insights and help provide peace of mind.

HomeLight can connect you with top-performing agents who have extensive experience in the local market and a proven track record of successful transactions.

By working with a knowledgeable agent, you can ensure that you’re making informed decisions and maximizing your investment potential.

Header Image Source: (Dillon Kydd/Unsplash)