How to Determine Investment Rental Property Values
When preparing to sell an investment rental property, its owner needs to accurately estimate its market value prior to establishing an asking price. A rental property's market value is based primarily on the net income it will provide its new owner and how that income compares with the return available from alternative investments. Other factors are the size, condition and location of the property. The most common method for estimating a rental property's value prior to sale is to apply a market capitalization rate (CAP rate) to its net operating income (NOI).
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Instructions
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Determine total annual operating revenue. Most of a rental property's revenue will, of course, be rent, but other operating income, such as laundry receipts or parking fees, should also be included. Whenever possible, numbers should be historical rather than projected. However, if scheduled future rents are being used, a realistic vacancy factor should be subtracted to estimate actual operating revenue.
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Determine annual operating costs. Operating costs should include property taxes, property insurance, any utilities paid by the owner, average maintenance and repair costs, and management cost. Even if the owner manages the property herself, a fee should be established to compensate her for her time. Note that debt service is not part of operating costs. Also, capital improvement costs that are beyond normal maintenance and repair should not be included.
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Determine Net Operating Income (NOI). Annual operating costs are subtracted from annual operating revenue to establish NOI.
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Determine a fair market CAP rate. The CAP rate is simply NOI as a percentage of the purchase price of the property. The CAP rate expected by an investor will depend primarily on the return available from alternative investments. CAP rates usually fall between 0.06 and 0.12, depending on factors such as size, condition and location. Real estate brokers who specialize in rental property can provide CAP rates for similar properties recently sold in the area.
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Estimate the property's market value. Value is calculated by dividing NOI by the market CAP Rate. For example, if NOI is $60,000 and the market CAP Rate is determined to be 0.075, the calculation is:
$60,000 / 0.075 = $800,000.
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Tips & Warnings
Recently sold properties used to establish a market CAP rate should be as similar to the subject property as possible. Large apartment buildings will normally have lower CAP rates than small two- or three-unit buildings, since small properties tend to experience higher revenue fluctuations.
If, in order to maintain current revenues, the buyer will have to incur additional costs to resolve deferred maintenance issues, those estimated costs should be deducted from the value established using the CAP rate method.
When calculating revenues, existing rental rates should be used, even if they are below market and could be immediately raised. Investors place little value on "potential".
The CAP rate valuation method does not take cost of financing into account, even though a prospective purchaser will factor in those costs when estimating his own return on investment. Different investors face different financing costs depending on personal circumstances. Therefore, those costs are not applicable when comparing a property to others that recently sold.
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