During the first half of the 2000s, investing in real estate became more common for average Americans. With easily available financing and minimal down payment requirements many Americans made handsome profits by flipping homes. Well, as we are all aware of, this could not go on forever, and the real estate bubble popped in 2007, leading to The Great Recession. Notwithstanding this fundamental change, real estate investment is certainly not unprofitable. Some economic factors such as high unemployment and very strict lending standards by financial institutions have contributed to low vacancies for rentals across the United States. Perhaps real estate investors should look at rental investments as an alternative to a buy and sell approach. So, how does one go about valuing real estate rentals? Here we will introduce at a high level some ways to value rental property.

TUTORIAL:  Sales Comparison Approach

The sales comparison approach (SCA) is one of the most recognizable forms of valuing residential real estate. This approach is simply a comparison of similar homes that have sold or rented over a given time period. Most investors will want to see an SCA over a significant time frame to glean any potentially emerging trends.

The SCA relies on attributes to assign a relative price value. Price per square foot is a common and easy to understand metric that all investors can use to determine where there property should be valued. If a 2,000 square foot townhome is renting for $1/square foot, investors can reasonably expect a similar rental income based upon similar rentals in the area. Keep in mind that SCA is somewhat generic; that is, every home has a uniqueness that is not always quantifiable. Buyers and sellers have unique tastes and differences. The SCA is meant to be a baseline or reasonable opinion and not a perfect predictor or valuation tool for real estate. It is also important for investors to use a certified appraiser or real estate agent when requesting a comparative market analysis. This mitigates risk of fraudulent appraisals, which became widespread during the 2007 real estate crisis.

TUTORIAL:Capital Asset Pricing Model

The capital asset pricing model (CAPM) is a more comprehensive valuation tool for real estate. The CAPM introduces the concepts of risk and opportunity cost as it applies to real estate investing. This model really looks at potential return on investment (ROI) derived from rental income and compares it to other investments that have no risk, such as United States Treasury bonds or alternative forms of real estate investments such as real estate investment trusts (REITs). 

Briefly, if the expected return on a risk-free or guaranteed investment exceeds potential ROI from rental income, it simply does not make financial sense to take the risk of rental property. With respect to risk, the CAPM considers the inherent risks to rent real property. For example, not all rental properties are the same. Location and age of property are key considerations. Renting older property will mean property owners will likely incur higher maintenance expenses. A property for rent in a high crime area will likely require more safety precautions than say a rental in a gated community. This model suggests building in these “risks” before considering your investment or when establishing a rental pricing structure. (CAPM helps you determine what return you deserve for putting your money at risk.

Income Approach

The income approach focuses on what the potential income for rental property yields relative to initial investment. The income approach should be used primarily when your market is commercial rThe income approach relies on determining the annual capitalization rate for an investment. This rate is simply the projected annual income from the gross rent multiplier divided by the original cost or current value of the property. Therefore, if an office building costs $120,000 to purchase and the expected monthly income from rentals is $1,200, the expected annual capitalization rate is 10%. 

This is a very simplified model with few assumptions. More than likely, there are interest expenses on the mortgage. In addition, future rental income may be less or more valuable five years from now than they are today. Many investors are familiar with the net present value of money. This concept applied to real estate is also known as discounted. Dollars received in the future will be subject to inflation as well as deflationary risk and are presented in discounted terms to account for this.

Cost Approach

The cost approach to valuing real estate states that property is really only worth what it can reasonably be used for. It is estimated by summing the land value and the depreciated value of any improvements. Appraisers from this school often espouse the “highest and best” use to summarize the cost approach to real property. It is frequently used as a basis to value vacant land. For example, if you are an apartment developer looking to purchase three acres of land in a barren area to convert into condominiums, the value of that land will be based upon the best use of that land. If the land is surrounded by oil fields and the nearest person lives 20 miles away, the best use and therefore the highest value of that property is not converting to apartments but possibly expanding drilling rights to find more oil. 

Another best use argument has to do with property zoning. If the prospective property is not zoned “residential,” its value is reduced since the developer will incur significant costs to to have the property rezoned. It is considered most reliable when used on newer structures, and less reliable for older properties. It is often the only reliable approach when looking at special use properties.

The Bottom Line

Real estate investing is not out of vogue by any stretch of the imagination. Since the last crash, however, the housing market has changed dramatically. Flipping homes financed with no money down is an artifact of the past and possibly gone forever. However, real estate rentals can be a profitable endeavor if investors know how to value real property. Most serious investors will look at components from all of these valuation methods before making a rental decision. Learning these introductory valuation concepts should be a step in the right direction to getting back into the real estate investment game.