5 Ways to Value a Real Estate Rental Property

Buying commercial or residential rental property has its attractions for investors. It can create a steady flow of income, with the added potential for property value growth over time. But before getting into the real estate rental game, an investor needs to know how to value rental property to make sure it yields the hoped-for return.

You could consider using more than one of these approaches to determine if the property you’re considering is likely to yield the return you’re expecting.

Key Takeaways

• Investors can use the sales comparison approach, the capital asset pricing model, the income approach, the gross rent multiplier approach, and the cost approach to determine property values.
• There isn’t a one-size-fits-all solution, so a combination of these factors can be useful.
• Estimating the potential return on an investment property is as important as determining the property’s value.

Where Are Rents Heading?

After a period of hot growth during the COVID-19 pandemic, monthly residential rent price growth has been decelerating. Annualized U.S. rent growth was just 1.7% as of October 2024, according to CoreLogic’s latest US Single-Family Rent Index.

1. The Sales Comparison Approach

The sales comparison approach (SCA) is one of the most recognizable forms of valuing residential real estate. It is the method most widely used by appraisers and real estate agents when they evaluate properties.

This involves a comparison of similar homes that have been sold or rented locally over a given time period. Most investors will want to see an SCA over a significant time frame to glean any emerging trends, good or bad.

The SCA relies on property attributes or features to assign a relative price value. These might include characteristics such as the number of bedrooms and bathrooms, garages or driveways, pools, decks, fireplaces—anything that makes a residential property unique and noteworthy.

Price per square foot is a common and easy-to-understand metric investors can use to determine the value of a property. If a 2,000-square-foot townhouse is renting for $1 per square foot, an investor can reasonably expect income in that ballpark from a comparable townhouse.

Example of Sales Comparison Approach

SCA is somewhat generic. Homes can be unique in ways that aren’t quantifiable. The SCA is a baseline or reasonable opinion, not a perfect predictor or valuation tool for real estate.

It’s a method that can be used to compare relatively similar homes.

You should use a certified appraiser or real estate agent when requesting a comparative market analysis. This mitigates the risk of fraudulent appraisals, which were widespread during the early- 2000s real estate bubble.

2. The Capital Asset Pricing Model

The capital asset pricing model (CAPM) is a more comprehensive valuation tool. The CAPM applies the concepts of risk and opportunity cost to real estate investing.

This model looks at the potential return on investment (ROI) derived from rental income and compares it to other investments that have no risk, such as United States Treasury bonds, or alternative forms of investing in real estate, such as real estate investment trusts (REITs).

In a nutshell, if the expected return on a risk-free or lower-risk investment exceeds the potential return from rental income, it simply doesn’t make financial sense to take on the risk of buying rental property.

Risk Factors

Location and property age are key considerations. Owning older rental properties can entail higher maintenance expenses for a landlord.

Property for rent in a high-crime area will likely require more safety precautions than a rental in a gated community.

This model suggests factoring in these risks before considering the investment or when establishing a rental pricing structure. CAPM helps you determine what return you are likely to get for putting your money at risk.

3. The Income Approach

The income approach focuses on the potential income for a rental property relative to the initial investment.

The income approach is used frequently for commercial real estate investing.

Important

The income approach is used frequently with commercial real estate investing because it examines potential rental income on a property relative to the initial outlay of cash to purchase the real estate.

The income approach relies on determining the annual capitalization rate for an investment. This rate is the projected annual income from the gross rent multiplier divided by the current value of the property.

So if an office building costs $120,000 to purchase and the expected monthly income from rentals is $1,200, the expected annual capitalization rate is: 14,400 ($1,200 x 12 months) ÷ $120,000 = 0.12 or 12%

This is a very simplified model with few assumptions. There could be additional costs such as interest expenses on a mortgage. Also, future rental incomes may be higher or lower five years from now than they are today.

Many investors are familiar with the net present value of money. Applied to real estate, this concept is also known as a discounted cash flow. Dollars received in the future are subject to inflationary as well as deflationary risks, and are presented in discounted terms to account for this.

4. Gross Rent Multiplier Approach

The gross rent multiplier (GRM) approach values a rental property based on the amount of rent an investor can collect each year.

This is a quick and easy way to measure whether a property is worth the investment.

Keep in mind that it does not consider other expenses such as taxes, insurance, and utilities. While it may be similar to the income approach, the gross rent multiplier approach uses gross rent, not operating income, as its cap rate.

The gross rent multiplier’s cap rate is greater than one, while the cap rate for the income approach is a percentage value. To get an apples-to-apples comparison, you should look at the GRMs and rental income of other, similar properties to the one in which you’re interested.

Example of Gross Rent Multiplier Approach

Let’s say a commercial property sold in the neighborhood you’re looking at for $500,000, with an annual income of $90,000. To calculate its GRM, we divide the sale price (or property value) by the annual rental income: $500,000 ÷ $90,000 = 5.56.

You can compare this figure to the one you’re looking at, as long as you know its annual rental income. You can find out its market value by multiplying the GRM by its annual income.

If it’s higher than the one that sold recently—i.e. for $500,000—it may not be worth it, so consider moving on.

5.The Cost Approach

The cost approach to valuing real estate states that property is only worth what it can reasonably be used for. It is estimated by combining the land value and the depreciated value of any improvements.

Appraisers from this school often reference the property’s highest and best use. It is frequently used as a basis to value vacant land.

For example, if you are an apartment developer looking to purchase three acres of land to convert into condominiums, the value of that land will be based upon the best use of that land. If the land is surrounded by oil fields and the nearest person lives 20 miles away, the best use and therefore the highest value of that property is not converting to apartments but expanding drilling rights to find more oil.

Another best use argument has to do with property zoning. If the prospective property is not zoned for residential purposes, its value is reduced, as the developer will incur significant costs to get the property rezoned.

This approach is considered most reliable when used on newer structures and less reliable for older properties.

It is often the only reliable approach when looking at special-use properties. These are properties like college dormitories or gas stations, which were developed for a particular purpose and are not easily adapted to another use.

Is Becoming a Landlord Worth the Trouble?

Many investors have found owning and renting real estate to be a worthwhile investment that creates a steady stream of income, with the additional prospect of property value growth over time. That said, there can be many issues in being a landlord, and they all involve time and money.

If you’re attracted to the real estate sector but prefer the hands-off approach, you might consider investing in a real estate investment trust (REIT) or a real estate fund.

How Can I Dodge a Downturn in the Real Estate Market?

Even more than most investors, a real estate investor needs to keep an eye on the economic news. Movements in interest rates have a big effect on demand. Shifts in the nation’s demographics matter. The overall health of the economy determines the health of the real estate market. Government policies and subsidies can turbo-charge the industry, or slow it down when the policies change.

They say you can’t time the markets perfectly, but in real estate, you have to give it a shot.

Which Performs Better Over the Long Run: Stocks or Real Estate?

Going strictly by the numbers, stocks have historically outperformed real estate. But the numbers don’t tell the whole story. Real estate is a physical asset with all that entails, particularly at the personal level of home ownership. It comes with numerous tax breaks, which is a plus, but it also comes with potential costs that don’t apply to stock ownership.

The Bottom Line

There is no one way to determine the value of a rental property. Most serious investors look at components from several or all of these valuation methods before making an investment decision about a rental property. They yield more concrete figures to work with when considering a prospective rental property.