Here’s How To Value an Investment Property
There are many ways on how to value an investment property depending on what you are interested in. Are you planning to sell your new investment soon or keep it for many years? Are you paying fully in cash or taking a loan?
If you are planning to keep a rental property for a while in order to make money out of it every month in the form of rent, then you should choose the income approach when you decide how to value an investment property. This method relies on calculating the capitalization rate, or cap rate, for the property, which measures the rate of return of an income property regardless of the method of financing. In a sense, this is a quite simplified approach as in the real world you will most likely need to pay interest on your mortgage which the cap rate does not take into account.
So, how to calculate the cap rate?
Cap Rate = NOI/Purchasing Price
NOI stands for net operating income, and it equals the annual rental income (monthly rent x 12) minus annual operating costs. So, let’s say that the property you are contemplating is being sold for $200,000, and you expect to be able to rent it out for $1,400 per month, while you estimate your annual operating costs at $4,000.
Cap Rate = (12 x $1,400 — $4,000)/$200,000 = 6.4%
Should you buy this income property? Well, probably not. While there is no agreement among experts on what’s a good cap rate, most tend to say 8%-12%.
Cash on Cash Return
Let’s face it. Most investors need to take a loan in order to finance the purchase of an income property, so let’s look at a more real-world example. When you wonder how to value an investment property, you can also use the cash on cash return you could expect. One benefit of this approach is that it allows you to factor in the loan that you will need to take. Let’s look at an example with a mortgage.
Cash on Cash Return = NOI/Total Cash Investment
If you want to buy a property worth $200,000 with a 20% down payment:
Down Payment = 20% x $200,000 = $40,000
You need to invest another $5,000 to rehab the property, so:
Total Cash Investment = Down Payment + Rehab Costs = $40,000 +$5,000 = $45,000
Now, calculating the NOI is a bit more complicated:
NOI = (Annual Rental Income — Operating Costs) — Debt Service
Debt Service = 6% x ($200,000 — $40,000) = $9,600 in case of 6% interest rate
NOI = (12 x $1,400 — $4,000) — $9,600 = $3,200
Cash on Cash Return = $3,200/$45,000 = 7.1%
Again, there is no right answer to the question of what constitutes a good cash on cash return, but most say it should be at least around 10%.
Gross Rent Multiplier
Another answer to the question how to value an investment property is through the gross rent multiplier (GRM). How to calculate the GRM?
GRM = Purchasing Price/Annual Rental Income
GRM = $200,000/12 x $1,400 = 11.9
And what does this number tell us? Generally, you want the GRM to be lower because it means you are making more compared to your initial investment. One thing you could do with the GRM is compare it to similar properties in your area. Another common rule of thumb you can use is that income properties with GRM below 10 or close it are likely to generate neutral or positive cash flow, and that’s what you want as a real estate investor. Alternatively, if the GRM is above 15, the cash flow is likely to be negative, so you should stay away from such investments. Continue reading > > >