Rental Appraisal: A Guide for Real Estate Investors

So, you've stumbled upon a rental property that seems promising. It seems like it's fairly priced, but how can you be sure you're not overpaying? Learning a few key rental appraisal fundamentals can help you assess the true value of the property.

Here, we'll explore the key techniques investors use in the rental appraisal process, like studying comparable sales, capitalizing income streams, and factoring costs.

Whether you're exploring your first rental investment or looking to expand your property portfolio, rental valuation methods will help you accurately appraise the property and confidently determine if the deal is right.

What is real estate appraisal?

Real estate appraisal is a way to estimate the market value of a property. For rental real estate investment properties, appraisers seek to determine the worth based on its income potential.

Appraisals play a key role in establishing a fair property price for sales transactions between buyers and sellers. The appraisal process provides investors with an estimate of potential gross rental income and allows lenders to evaluate the collateral value for mortgage financing. Finally, appraised values impact property tax obligations and insurance coverage requirements.

Different methods for appraisal

There are several different ways to calculate the value of a rental property. Let's look at five common appraisal methods that many investors use:

1. Sales comparison approach

The sales comparison approach checks recent sales of similar properties. This is something that real estate agents can do by looking at pricing of comparable residential properties that have recently sold in the same area with the same features.

This is a commonly used approach for single-family rental appraisals. Here's how a real estate agent uses this method for property values:

1. Identify comparable sales: Find 3-5 recent sales of similar properties.
2. Adjust comparable prices: If a comp in the area is superior to the subject property in some regard (e.g. it has an extra bedroom), subtract a value from its sale price based on your local market data. Or, if the property's inferior (e.g. older than the subject property), add a value.
3. Calculate adjusted sales price: For each comparable, the agent now has an adjusted sales price.
4. Estimate property value: The estimated value of the subject property is typically an average of these adjusted sales prices, giving you an approximate market value.

Example:

• Property: 1500 sq. ft, three beds, two baths.
• Comparable A: Sold for $260,000; -10% adjustment for fewer bedrooms/bathrooms.
• Comparable B: Sold for $275,000; +5% adjustment for smaller size.
• Comparable C: Sold for $250,000; identical, no adjustment.

The estimated value of this residential property, after making adjustments based on the local market, is approximately $265,000.

2. Income approach

The income approach to valuing a rental property helps investors to estimate the value of a property based on potential rental income. This approach is particularly relevant for investment properties such as apartments or commercial property. 

Here are the factors for the income approach:

• Gross rental income: The total annual income the property generates from all sources, including rent and any other income like parking fees or laundry services. If the current property is not a rental, you can use Azibo's rent estimator to get an idea of potential income.
• Operating expenses: The annual costs involved in maintaining and operating the property. These can include management fees, maintenance, property taxes, insurance, and utilities not covered by tenants.
• Net operating income (NOI): The actual income from the property after you deduct operating expenses.
• Capitalization rate (cap rate): A rate used to estimate the return on an investment property. It's determined by the market and varies by location and property type.
• Property valuation: The estimated value of the property, calculated by dividing the NOI by the cap rate.

Example:

• Gross rental income: $50,000/year
• Operating expenses: $15,000/year
• Net operating income: $35,000/year
• Cap Rate: 6%
• Valuation: Approximately $583,333

The estimated value of this investment property using the income approach is approximately $583,333.

3. Gross rent multiplier approach

The gross rent multiplier (GRM) is a simple method that focuses solely on the gross rental income. It's focused on the ratio of the property's price to its annual rental income. The components of this appraisal method include:

• Gross rental income: The total annual income generated from the property, including all rent and other income sources like laundry or parking fees.
• Sale price of comparable properties: The selling price of similar other properties in the area.
• Gross rent multiplier: A ratio that compares the property's sale price to its annual gross rental income.
• Property valuation: Estimated by multiplying the GRM with the property’s annual gross rental income.

Example:

• Sold property GRM: $300,000 sale price / $30,000 annual income = GRM of 10.
• Comparable property: Annual income of $40,000.

Using the gross rent multiplier approach, the value of this property is $40,000 *10 = $400,000.

The GRM approach is useful for quickly comparing and valuing properties, especially in markets where comparable sale data is readily available. But to fully vet an investment property, use this method along with other approaches for a more accurate assessment.

4. Cost approach

The cost approach gauges the value of a property based on the cost of constructing a replacement. This approach is useful for unique or new properties where comparable market data is scarce.

The approach involves several components:

• Land value: The value of the land if it were empty.
• Construction cost: The current cost to construct a new building similar to the existing one.
• Depreciation: The loss in value of the building due to aspects like wear and tear or outdated features.
• Depreciated building cost: The construction cost minus the depreciation.
• Total property value: The sum of the depreciated building cost and the land value.

Example:

• Land value: $60,000
• Construction cost: $180,000
• Depreciation: $30,000
• Depreciated building cost: $150,000

If you use the cost approach for this rental property, the value is $150,000 + $60,000 = $210,000.

5. Capital asset pricing model

Investors use the capital asset pricing model (CAPM) to calculate the expected return on a property and the risk of the property compared to the overall market. Valuing a rental property based on this method includes the following components:

• Risk-free rate: The return from a completely safe investment, like government bonds. This is the baseline return with no risk.
• Market return: The average return expected from the entire real estate market.
• Property risk (beta): This measures the property's risk compared to the average market risk. A beta higher than 1 means the property is riskier than the market average.

The idea is that investors should at least earn the risk-free rate. Any additional risk taken should have a higher return.

Example:

• Risk-free rate: 2%
• Market return: 8%
• Property risk (beta): 1.2
• Expected return: 2% + 1.2 × (8% - 2%) = 9.2%

So, the expected return on the property is 9.2%. Investors can then determine if the potential profit is worth the risk.

The value of the rental property appraisal

Before you buy a rental property, you want to make sure your investment is worth it. In addition to considering the initial investment, anticipated monthly income, and potential ROI, you should feel confident that you are investing your hard-earned money in a promising opportunity.

As a prospective property owner, using these rental appraisal methods help you weigh the opportunity cost against other investment options, such as the stock market. Assessing a property's value and its income-generating potential is a helpful skill in real estate investing.

Regardless of the approach you choose, be sure to analyze the data to verify the property's estimated value and associated risk factors to make the best decision.

Appraisal for rental property FAQs

What is a good cap rate for rental property?

Generally, a good cap rate for rental property is anywhere from 5% to 12%.

How do you calculate rental income?

To calculate rental income, sum up all the income generated from renting out the property, including monthly rent payments and any additional income sources like parking fees or laundry services.

How long does it take to complete rental property appraisals?

Rental property appraisals usually take around 1 to 2 weeks to complete but can be influenced by factors like property complexity and the appraiser's workload.