It's critical that real estate agents and brokers who work with investor clients understand income property valuation methods if they're going to do their jobs properly. A commonly used valuation method combines income and the capitalization rate to determine the current value of a property being considered for purchase.
In addition to a property's market value, one of the first things you'll want to do as a real estate investor who's considering buying a purchase is determine is its operating income and costs. This information will tell you if the property meets your cash flow and profitability goals and expectations.
The Cap Rate
Cap rate represents your anticipated return after one year as if you had bought with cash. Understanding cap rate is vitally important to your future business growth, particularly if you're just starting out.
Calculate Property Value
First determine the net operating income (NOI) of your subject property. The NOI of a rental property is its rents less its expenses. Determine the net rental income after what it costs to maintain the building if it's an apartment complex.
This can be a bit of a challenge because you'll need the income and expense statements, and only the current owner is likely to have this information. But you can also estimate NOI by multiplying the sales price by the capitalization rate after you've nailed down the cap rate.
A Calculation Example
A six-unit apartment project might yield $30,000 net profit from rentals. Determine the capitalization rate from a recent, comparable, sold property. Now divide that net operating income by the capitalization rate to get the current value result.
Let's say your comparable sold for $250,000. You've determined that the property's NOI after deducting applicable expenses is $50,000. Divide that by the $250,000 sales price. You have a capitalization rate of .2, or 20%.
Assuming a capitalization rate of 20%, $30,000 divided by that percentage is $150,000. This would be the current value.
Keep in mind that this isn't the only method for calculating income property values—it's just one tool in the box. The various valuation and financial performance calculations that investors and real estate professionals use in their daily routines all have some value.
For example, few properties are purchased with cash and no financing, so another calculation method used might be a cash-on-cash return.
There are books full of complicated calculations you can use to value real estate and determine the performance of real estate investments and rental property ownership and operations. Some apply to wholesaling, some to fix-and-flip projects, while still others apply to rental investing. Some are more useful to the rental investor in determining the long-term performance of their portfolios.
Most investors only use half a dozen or so of these calculations regularly for residential property investment.
Commercial Property Investment
A whole new level of math is involved in commercial investment. Lenders use some very specialized calculations to determine whether to finance purchases or projects.
Choosing which valuation and profit calculations to use depends on your goals and the property type. You probably won't be all that interested in cap rate and other multi-family-oriented calculations if you're an investor buying single-family rental properties.
Rental Property Investment
The beginning of a successful rental property investment strategy is an accurate estimate of rental yield for the prospective property. The net rental yield tells you just how well your investment is doing, not only with market factors and rent included, but also with your costs, including management and maintenance.
The Bottom Line
Those who invest in real estate via income-producing properties should have a method to determine the value of any property they're considering buying. Cap rates are widely used in commercial and multi-family property valuation and profitability studies. They can be used to determine a good sales price, or the value of a listed property versus the asking price.