There's an old adage in the real estate industry that says the real money is made when a property is purchased, not when it is sold. Understanding the value of a rental property is crucial before investing, as it helps you avoid overpaying or missing out on a good deal. In this article, we will explore the difference between gross and adjusted rental income and learn how to calculate property value based on rental income.
Gross and Adjusted Rental Income: What You Need to Know
Gross rental income refers to the total amount of money collected from a tenant, including monthly rent, late fees, and additional income from sources like pet rent, parking, and application fees. It's important to note that a refundable tenant security deposit is not considered rental income unless it is used to cover damages caused by the tenant.
Adjusted rental income, on the other hand, takes into account the revenue lost during periods of tenant turnover. Rental properties are rarely occupied 100% of the time, year after year, without any vacancy days. Adjusted rental income factors in a vacancy allowance to account for this lost income.
Let's take a look at an example to understand how gross and adjusted rental income are calculated:
- Rental income: $18,000
- Pet rent: $600
- Total gross rental income: $18,600
- Vacancy allowance: -$930
- Adjusted rental income: $17,670
In this example, the vacancy allowance of -$930 is based on a vacancy factor of 5%. This means that we assume the property will be vacant for around 18 days each year (365 days x 5%), and we subtract 18 days' worth of rental income from the total gross rental income.
It's worth noting that the 5% vacancy factor used in this example is just an estimate. When calculating a vacancy allowance and adjusted rental income, it's common for investors to consider a rental property's historical vacancy percentage or consult with a local property manager if the property has never been rented before.
4 Methods to Calculate Property Value Based on Rental Income
Now, let's explore four different methods you can use to calculate property value based on rental income:
1. Stessa Valuation Tool
One of the methods available for calculating property value is through the Stessa Valuation Tool. By signing up for a free account with Stessa, you gain access to this handy tool. Stessa provides real-time property market values and return metrics based on key variables. The tool offers an estimated market value called the Zestimate, which is calculated using Zillow's proprietary formula.
Additionally, Stessa users can switch between different valuation methods with just one click. The income/cap rate approach and the gross rent multiplier (GRM) valuation method are two other valuation methods you can use. Regardless of the method chosen, Stessa updates the property value automatically to provide investors with a more accurate idea of their equity.
2. Income/Cap Rate Approach
The income approach formula values a rental property based on net operating income (NOI) and the capitalization rate (cap rate). NOI is calculated by subtracting operating expenses from adjusted gross rental income, while cap rate is calculated by dividing NOI by the property's value or purchase price:
- Cap rate = NOI / property value or purchase price
Operating expenses can be determined based on a property's historical and anticipated future expenses or using the 50% Rule for properties that have never been rented before. The 50% Rule estimates operating expenses by multiplying the adjusted gross rental income by 50%. For example, if the adjusted gross rental income is $17,670, the operating expenses should be no more than $8,835, and the NOI should be at least $8,835.
Here's an example of how to use the income approach to calculate property value:
- Adjusted gross rental income: $17,670
- Operating expenses: $7,950
- NOI: $9,720
To find the property value, rearrange the cap rate formula:
- Cap rate = NOI / property value
- Property value = NOI / cap rate
- $9,720 NOI / 6% cap rate = $9,720 / .06 = $162,000 property value
3. Gross Rent Multiplier (GRM)
The gross rent multiplier (GRM) approach calculates property value based on gross rental income without factoring in operating expenses. While it may be considered a simplistic way of determining property value, it provides a quick estimate based on gross rental income.
GRM is based on the concept that the more gross rental income a property generates relative to its purchase price, the better the value. For example, if the property value is $162,000 and the gross rental income is $18,600, the GRM would be:
- GRM = property value or purchase price / gross rental income
- $162,000 property value / $18,600 gross rental income = 8.7
A lower GRM compared to similar rental properties in the area indicates better value, as it means the rental property generates more rental income relative to its price. You can also use the GRM formula to calculate property value based on rental income. For example, if the GRM for similar properties in the area is 8.7 and the gross rental income is $18,600, the property value would be $161,820:
- Property value = gross rental income x GRM
- $18,600 x 8.7 GRM = $161,820 property value
4. Sales Comparison Approach
The sales comparison approach, also known as "comps," involves looking at recently sold properties in the same area that are similar to the subject property. By comparing these properties, you can determine the value of the subject property.
For example, let's say the subject property has an asking/sold price of $162,000, while comparable properties have different features. Adjustments are made to the value of the comparables based on these differences:
| Subject | Comp #1 | Comp #2 | Comp #3 |
|---|---|---|---|
| Asking/sold price | $162,000 | $160,000 | $150,000 |
| Square feet | 1,200 | 1,250 | 1,250 |
| Beds/baths | 3/3 | 3/2 | 3/3 |
| Bathroom adjustment | $0 | +$5,000 | $0 |
| Garage | No | Yes; -$2,000 | No |
| Adjusted value | $162,000 | $163,000 | $150,000 |
| Price/sqft | $135/sqft | $130/sqft | $120/sqft |
After valuing a property using the sales comparison approach, it's essential to consider the property's gross rental income and operating expenses. Factors such as rent prices of comparable properties in the same area and actual or projected operating expenses should be taken into account. For example, even if the subject property has a higher price per square foot, it may offer additional amenities that could justify a higher asking rent and a greater potential return on investment (ROI).
By understanding these four methods, you can confidently determine the value of a rental property based on its income. Remember to consider local market conditions and seek expert advice when necessary. With this knowledge in hand, you'll be better equipped to make wise investment decisions in the real estate market.