Real estate valuation for single family homes is typically done by using comparable sales. This basis however is not as effective in the case of rental properties. Imagine if you are looking at a 24-unit building. It would be difficult to find similar ones nearby that have recently sold.
Likewise, using replacement costs as the basis for appraisal is impractical. It will work only if there is a recent sale of a land recorded in a properly zoned area. On the other hand, this method will be useful if you are making a decision on whether to buy or build.
The Cap Rate as the Basis of Property Valuation
The income motive is the reason for the purchase of income properties. Income, then, is what is used to determine value. The cap rate (capitalization rate) is the expected return on the investments of the property owner in that area. This is one approach when making an evaluation of the value of an income property. Below is a somewhat simplified explanation.
Start the computation with the gross rental income for the year. Then deduct all your operating expenses except your loan amortizations. Assume a gross annual income of $82,000.00, and your expenses total $30,000 for the same period, then you have a net income of $52,000 before your loan payments. The next step is to use the cap rate to your net income.
The capitalization rate is the figure that is generally used by the real estate industry in the area, so if the players expect a 10% annual return on their property, the cap rate is 0.10. If you divide your net income by .10, the result will be $520,000 which will be the appraised value of the property. Let as assume that the accepted cap rate used by property investors in the area is .08. Then the value would be $650,000.
An Overly Simple Real Estate Valuation?
Take net income before debt-service, and divide by the “cap rate:” It’s a simple formula. The important factor therefore would be the accuracy of the assumed income. Did the seller show you ALL the normal expenses? Did he and exaggerate the income? What if he stopped repairs for a year and projected a gross rental income? Your income would be overvalued by as much as $15,000. If the cap rate used is .08, then the appraisal is overstated by $187,000.
Experienced investors do not include incidental income from vending and laundry machines and other sources. If incidental income accounts for $6,000, that would result to an overvaluation of $75,000 based on the .08 cap rate. A more favorable process would be to exclude incidental incomes from the gross, and to include the replacement costs of the machines (should be less than $75,000) to get the appraised value.
The lesson is to be prudent when using a real estate valuation formula. There is no perfect appraisal method, and all are only as good as the figures you plug into them. Provided that the figures are accurate, the cap rate valuation approach would be a realistic appraisal method.
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