How do you calculate the purchase price of a rental property?
Have you been thinking of buying a rental property?
When it comes to real estate investment, there are many things to consider. What is the cost of the property? How much will you get back in returns? Will the property appreciate over time? The most important factor that most investors are concerned with is understanding the value of a property. Now, rental properties are not valued the same way as residential properties. The idea behind buying a rental property is to get monthly rental income. If you overpay for a property, the returns will not be to your liking. On the other hand, buying a property at a below-market rate may help you earn bigger profits.
So, what is the "right" price for a rental property? How do you calculate the purchase price?
What is the right price for a rental property?
The truth is, there is no "right" price for a property. What is right for one buyer could be the wrong price for another. Every piece of property is unique. Similarly, the reason for buying a property is different for different investors.
Say, you are more interested in appreciation. In that case, you may be comfortable buying a property with little or no cash flow. For instance, home values in Austin, Texas have appreciated by 22% in the last year. That means a home worth $400,000 bought a year ago would now be worth about $488,000. That's a profit of $88,000. Of course, there are areas where property prices have depreciated, and buyers have incurred losses. The risk with real estate markets is that it moves in cycles.
In the case of rental properties, investors would usually consider cash flow or a
combination of cash flow and appreciation to determine the right price. Some pertinent questions to ask when pricing a rental property are:
- How much can you earn based on the current market rent?
- Would you be able to increase the rent in the future?
- What are the operating expenses?
The answer to these questions will help you determine how much potential return you can earn based on the offer price.
If your priority is cash flow, you may want to invest in an area where the demand for rental properties is high. Of course, the purchase price may be higher, but you will also be earning higher returns.
How to calculate the purchase price of a rental property?
A simple Google search for property price calculators would throw up various results, including vacation rental property calculators, single family and multifamily investment calculators, and more. However, there is no single way to determine the value of a rental property. Investors usually use more than one way to arrive at a potential range of values for a certain rental property.
The sales comparison approach
The sales comparison method is perhaps the most common way real estate investors and appraisers determine the value of a property. This method compares the prices of homes that have been recently sold over a certain time frame. They may look at similar properties that have been sold in the last 30 days or so to determine the value of a rental property. However, it is also necessary to consider the activity levels of the local real estate market.
The sales comparison method considers features or attributes to assign a relative price value. For instance, it may consider the number of bedrooms in the house, pools, garages, and so on. Any attribute that makes the property noteworthy adds value to it.
The Income approach
The income approach considers the NOI (net operating income) generated by the property compared to its purchase price. NOI considers property operating expenses only and does not consider mortgage payments, repair costs, and so on.
The capitalization rate is calculated by dividing the first year of NOI by the property price.
Capitalization rate= NOI/ Property Value
Properties that have a high capitalization rate are considered better investments. However, it is possible to increase the capitalization rate by increasing rent over time and keeping operating expenses under control.
The cost approach
The cost approach is used when a rental property is not generating any income or when recent sales are difficult to come by. The idea behind this approach is that an investor would not pay anything more than what it would take to build the same home from scratch.
The formula for determining the value of a rental property using the cost approach is:
Property value= Cost-Depreciation+ Land value
Reproduction and replacement are the main valuation methods used in this approach.
The reproduction valuation method determines property value based on how much it would cost to build a house using the same materials, floorplan, and fixtures. The replacement method uses a new floorplan along with new materials and fixtures.
The capital asset pricing approach
The concept of opportunity costs and risks are taken into consideration in the capital asset pricing model. That is why it is considered a more comprehensive approach to property valuation.
This model compares the potential ROI on a certain rental property with other risk-free investment options, such as US Treasury bonds or REITs (Real estate investment trusts). If the returns from risk-free investments are higher than the returns from the rental property, it is not a wise decision to invest in such a property.
When it comes to risks, the capital asset pricing model looks at all the inherent risks, such as the age of the property, location, and so on. For instance, the demand for rental properties in a gated community is higher than those in a high-crime area. If you do buy a property in a risky area, you will need to put safety measures in place, which will require more investment.
The gross rent multiplier approach
The gross rent multiplier approach considers the amount of rent an investor can earn in a year. It is a pretty simple way to determine if a property is worth buying. However, it may not be the most efficient method because it does not take into consideration factors like insurance, taxes, utilities, and other expenses on the property.
What is a good rate of return on rental property?
The ROI (Return on Investment) of a rental property measures the profitability of that property. For instance, if you have bought a property for $200,000 and the ROI is 5%, you should roughly be getting a profit of $10,000 per year.
Now, different people have different opinions about what is a good ROI for rental properties. Some are happy with a 7% to 10% return, while others are looking for a much higher rate of return.
Typically, 15% or more is considered to be a great return on your investment. However, some investors would not even consider a property if it does not give 20% or more ROI. So, it all boils down to your personal preferences and goals.
However, the turnover rate and vacancy rate also influence your ROI. If you are unable to retain your renters, and your turnover rate is high, your ROI may be lesser. That's because you would need to invest in marketing and other promotional activities to find new renters. The more the number of days your property remains vacant, the more money you lose.
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