There's a saying in the real estate world that money is made when a property is purchased, not when it is sold. Before investing in real estate, it's essential to know the value of a rental property to avoid overpaying or missing out on a great deal. In this article, we'll explore the crucial difference between gross and adjusted rental income and learn how to calculate property value based on rental income.
Gross and Adjusted Rental Income Calculation
Gross rental income is the total amount of money received from a tenant, including monthly rent, late fees (if any), and miscellaneous income from sources like pet rent, parking, and application fees. However, a refundable tenant security deposit is not considered rental income unless it's used to pay for damages caused by the tenant.
When assessing a rental property for purchase or refinancing, investors use a metric called "adjusted rental income." Adjusted rental income includes a vacancy allowance to account for the rental income lost during periods of tenant turnover. It acknowledges that rental properties are not occupied 100% of the time, year after year, without any vacancy days.
To calculate adjusted rental income, let's consider the following example:
- Rental Income: $18,000
- Pet Rent: $600
- Total Gross Rental Income: $18,600
- Vacancy Allowance: -$930
- Adjusted Rental Income: $17,670
The vacancy allowance of -$930 is based on a vacancy factor of 5%. We assume that the property remains vacant for approximately 18 days each year (365 days x 5%) and subtract the lost rental income for those 18 days from the total gross rental income.
It's important to note that 5% is just an estimate used for this example. When calculating a vacancy allowance and adjusted rental income, investors typically look at a rental property's historical vacancy percentage or consult with a local property manager if the home has never been rented before.
Four Methods to Calculate Property Value Based on Rental Income
Let's explore four different approaches to calculate property value based on rental income:
1. Stessa Valuation Tool
One of the many benefits of signing up for a free account with Stessa, a Roofstock company, is accessing the Stessa Valuation Tool. This tool calculates property market values and return metrics in real-time based on key variables. The default valuation method provides an estimated market value, known as a Zestimate, based on Zillow's proprietary formula.
Stessa users can also switch between valuation methods with just one click. Other valuation methods available include the income/cap rate approach and the gross rent multiplier (GRM) valuation method. Whichever method is used, Stessa automatically updates the property value on the real estate balance sheet 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 its net operating income (NOI) and cap rate (capitalization rate). NOI is calculated by subtracting operating expenses from adjusted gross rental income, while cap rate is determined by dividing NOI by the property's value or purchase price.
An investor can estimate operating expenses based on a property's historical and anticipated future expenses or use 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, with adjusted gross rental income of $17,670, 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. Let's assume similar rental properties in the area trade at a cap rate of 6%.
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Calculate NOI by subtracting operating expenses from adjusted rental income:
- Adjusted Gross Rental Income: $17,670
- Operating Expenses: $7,950
- NOI: $9,720
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Use the cap rate formula to determine property value:
- 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 this method is simplistic, it provides a quick estimate of property value based on gross rental income.
The GRM is based on the concept that the higher the gross rental income compared to the purchase price, the better the value of the property, assuming all other factors are equal. For instance, if the property value is $162,000 and the gross rental income is $18,600, the GRM would be:
- GRM = Property Value / 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 implies a better value. This means the rental property generates rental income equal to the property value in 8.7 years, assuming the rental income remains constant.
The GRM can also be used to calculate property value based on rental income by rearranging the formula. Assuming GRMs for similar rental properties in the area are 8.7, and the gross rental income is $18,600, the property value would be:
- 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 analyzing recently sold comparable properties in the same area. The property being valued is called the "subject property," while the comparison properties are referred to as "comparables."
To use the sales comparison approach, potential buyers adjust the value of the comparables compared to the subject property. For example, if a comparable property has an additional bathroom, its value is adjusted downward, and vice versa. This approach helps determine the fair market value of the subject property based on recent sales of similar properties.
After valuing a property using the sales comparison approach, it's crucial to consider the property's gross rental income and operating expenses. Factors such as rent prices of comparable properties in the area and actual or projected operating expenses should be taken into account. A higher price per square foot doesn't necessarily indicate a better investment if the property's location justifies higher rent and a greater potential return on investment.
Calculating property value based on rental income is a vital step in real estate investment. By understanding the different methods and considering key factors, you can make informed decisions and ensure the profitability of your investments.
Remember, the value of a rental property goes beyond its purchase price. It's about generating steady rental income and maximizing your return on investment in the long run.