The job of a real estate appraiser is to research local rental markets in part to arrive at an estimate of market value for rental income property. As a result, they are highly qualified when it comes to property valuation and we novices can certainly learn from them to advance our own real estate objectives.
So in this article, we’ll discuss three of the approaches or methods appraisers use to determine rental income property market value hoping you will get the idea how each method works and can apply it to benefit your investment purposes.
1. Income Approach
The income method estimates the anticipated income stream the rental income property is expected to produce and then converts it into a market value amount.
In this case, you would use the rate of return that you or a real estate investor desire from a cash investment and then capitalize that percentage by the net operating income being produced by the property.
Let’s say you desire a 8.5% rate of return on your real estate investment and estimate that the subject rental produces an annual net operating income of $38,500.
To arrive at the rental property’s market value based upon its income stream (NOI) and your desired return on investment you would divide the property’s net operating income by your desired rate of return.
Net Operating Income / Desired Return = Market Value
$38,500 / .085 = $452,940
Income Approach = $452,940
2. Market Data Approach
The market data method compares the subject property to with other similar rental properties that recently sold and then determines a market value based upon data associated with those comparable (comp) properties.
Bear in mind, however, that for this method to work, each comp should be in similar areas, with similar unit sizes, amenities, appearance and rent structures, and should all be buildings that have sold recently.
Let’s use price per unit, for instance. In this case you would divide the price at which each rental sold by the number of rentable units in each building and then compute an average price per unit to use as a multiplier – which in turn is applied to the subject rental income property.
Let’s say you settle on six comparable income-producing properties in the local area that sold for an average cost of $60,000 per unit and want to determine the market value for a 7-unit building.
You would determine your subject property’s market value by multiplying its number of units by the average cost per unit for the comparable properties.
Number of Units x Average Cost Per Unit = Market Value
7 x 60,000 = $420,000
Market Data Method = $420,000
3. Cost Approach
The cost method approach concerns an estimate of what it would cost to replace the rental income property at today’s prices. That is, what it would it cost to buy the land today and build a building identical to the subject property (but after an adjustment for wear and tear).
This method is somewhat more complex than the previous methods because it does involve a series of value computations before you can arrive at a market value for your subject property.
a. Land Value
You must do some research about land value costs for similar income properties in your local market and settle on an average cost per square foot that you can apply to the subject property.
For instance, if a study indicates comparable land is selling for an average cost of $10 per square foot and the subject property is on a 100 x 200 foot lot (or 20,000 square feet) then you would apply the math.
Cost Per Square Foot x Square Footage = Land Value
$10.00 x 20,000 = $200,000
Land Value = $200,000
b. Site Improvements
Here you must determine what it would cost to replace the site improvements of the rental income property such as the parking area, lawn, shrubs, trees, and so on associated with the subject building.
This may involve tallying up the bids you get from local contractors – which, for simplicity sake, we will say totals $30,000.
Site Improvements = $30,000
c. Building Replacement
This concerns what it would cost – using similar type and quality of construction – to duplicate the building’s square footage of the living areas, garages and utility areas (if applicable), and then adjusting for wear and tear (or depreciated value).
All of this, of course, would require research and knowledge of local building costs. For our purposes, we will assume that the subject rental income property has a total 4,200 square feet and building costs are $60.00 per square foot. Moreover, because the building is several years old we will assume that it has depreciated 20% in value.
Building Costs x Square Footage = Building Duplication
Building Duplication x Percent of Depreciation = Depreciated Value
Building Duplication – Depreciate Value = Building Replacement
$60.00 x 4,200 = $252,000
$252,000 x .20 = $50,400
$252,000 – 50,400 = $201,600
Building Replacement = $201,600
+ Site Improvements
+ Building Replacement
= Market Value
Cost Method = $431,600
Arriving at Market Value
Okay, having completed the three valuation methods for our subject rental income property we also arrived at three estimated market values.
Income Approach: $452,940
Market Data Approach: $420,000
Cost Approach: $431,600
For our final estimation we must correlate all three of the appraisal methods and simply make a judgment on which we want to put a slightly heavier emphasis. By leaning more on the income approach, for instance, we could arrive at a value of $440,000. Putting the emphasis on one of the other methods could result in a different estimate of our rental income property value. You get the idea.