Investing in rental properties and real estate isn’t just a question of whether or not you can turn a profit immediately. It’s also about how much profit you can make in the long term. Just because a region or neighborhood has high rent, doesn’t mean investing in a rental property in that neighborhood is a good idea.
Also, just because real estate is valuable and you can potentially turn a high profit, doesn’t mean overpaying for the property is a good idea. You don’t want to bid against people with deeper pockets who don’t have to worry about taking a loss or plan to make it their primary home. You also don’t want to bid against yourself. The best way to ensure you’re paying a reasonable price on a rental property is to know how to calculate that value. Here is one way to do it:
What to know
Gross rental income: This is the total amount of rent collected without adjusting for any costs or losses.
Adjusted gross rental income: This is the total amount of income collected from rent minus the losses from times the property sat vacant and waiting for a new tenant.
How to calculate
Calculating gross and adjusted rental income isn’t too complex and anyone can do it. Calculating gross income is just adding up all the money you collect from various fees. These fees include rent as well as any other miscellaneous charges like parking and pet rent. This also includes any late fees if you collect any. This does not include any refundable security deposits paid by the tenants.
Calculating the adjusted gross rental income is a little more complex but still very simple. What you are calculating is an allowance for the expected amount of days the rental unit is left vacant annually. The way to calculate this is to find out how much rent is per day based on the annual total along with any other regular fees like pent rent and parking fees.
Let’s just say rent is $2,000 a month and there are no other fees. That means the total possible amount to be collected would be $24,000 annually. Let’s say there is a 5% expected vacancy rate. This means you can expect the rental unit to be vacant 18 days out of the year. At full vacancy, the property would be earning $65.75 per day. Multiply that by 18 and subtract it from $24,000 and you will arrive at an adjusted gross rental income of $22,817.
When calculating adjusted gross rental income, 5% is just a good starting point. You’ll want to use real data based on the property history or comparable regional data to get a better picture of what to expect.
The different methods
The Income/cap rate method: This is used to value the property based on the net operating income and the cap rate. To calculate the net operating income, subtract all of the expenses from the adjusted rental income. In order to calculate the cap rate, calculate by dividing the net operating income by the purchase price. When determining if the property is worth investing in you’ll want to use the 50% rule. This means you want the operating costs to be no more than 50% of the adjusted gross rental income.
Gross rent multiplier: This is a very simple calculation you can use as a starting point. The basic idea is that the more rent you can collect from a property, the more valuable it is. While this won’t account for the actual costs of operating a rental property or any of the unforeseen risks, it will give you a ballpark figure of how much a property is worth. The way to calculate this is to divide the price of the property by the gross rental income. This will tell you how many years it’ll take to collect income that is the same value as the property.
Sales comparison approach: This is a way of looking at a property and calculating the value based on what similar properties have sold for recently in the same area. This means you are using the characteristics of the property and comparing them to other properties in the area with similar characteristics and what they sold for. This method may not tell you if a property is a wise investment, but it can give you a jumping-off point of what the right price would be.
Using them all
There’s no one right way to assess the value of a property. At the end of the day, it depends on who you are bidding against and how the local economy does over the long term, but in order to protect yourself from bad investments, it is wise to use every data point available to you.