In many areas of California, real estate is approaching or surpassing all-time record high valuations. Current homeowners are enjoying the increased equity they seem to be generating every single month. Investors are eager to make the most of the hot market as well. Not only are property values climbing, but the rent an investment property collects each month is going up as well. Even so, there are still plenty of overpriced assets on the market, and smart investors are doing all they can to avoid these pitfalls. Without proper valuations prior to purchasing a property, an investor can sink their portfolio before it even gets underway. In this blog post, we are going to go over some of the methods that can be utilized to ensure you properly value a property.
The income approach
The income approach calculates the value of a property by determining the annual capitalization rate. This figure is calculated by taking the annual projected income and subsequently dividing it by the current value of the asset. For example, if a rental property costs $200,000 to buy, and the rent collected every year is going to be $18,000 ($1,500 per month x 12 months) then the annual capitalization rate would be 9%.
In most instances, a property with anywhere between an 8-12% cap rate is considered to be a good investment. If demand in the area is high, the cap rate will likely be lower. Popular metropolitan areas like Los Angeles and San Francisco can yield a cap rate of closer to 4% and still be considered a solid investment. The income approach is relatively simple, and it’s important to take into consideration things like mortgage interest expense to ensure you have a clear picture of the value of the asset.
The sales comparison approach
The sales comparison approach is probably the most popular valuation model for residential real estate. Both real estate appraisers and real estate agents tend to utilize this method more frequently than others. In order to use this method, look for similar properties in the geographic area that have been sold or rented out recently. Potential investors may want to see the sales comparison approach calculated for a few years at a time so that they can zero in on any positive or negative trends that may be happening in the area.
This method relies heavily on the comparisons being apples to apples. Things like square footage, number of bedrooms, and lot size need to be accounted for properly. You can also calculate a price per square foot as a basis for comparison. Once you have a price per square foot, it’s reasonable to expect similar value in similar properties in the same area.
Gross rent multiplier
This method is based on determining the amount of rent that an investor can expect to collect from the asset annually. The calculation is pre-utility, taxes, and insurance expenses so it’s important to adjust for those numbers when considering the overall value. GRM is similar to the income approach, but it does not use a capitalization rate. Instead, this method focuses on the gross rent expected.
To calculate the gross rent multiplier, simply divide the cost of the asset by the amount of rent you are expecting to collect each year. For example, if a property is priced at $300,000 and you will collect $36,000 in annual rent ($3,000 per month) then your Gross Rent Multiplier would be 8.33%. With GRM, the lower the number, the better. A good range is usually somewhere between 4 to 7. However, just because the number is higher than 7 doesn’t necessarily mean it’s a bad investment. It simply means that the asset might take longer to pay for itself than one with a lower gross rent multiplier.
Be sure to look for a future blog post where we will continue the discussion and look at alternative valuation strategies. As always, please contact PMI Patron with any Fullerton property management questions or inquiries.