There’s a saying in real estate that money is made when a property is purchased, not when it is sold. Before investing in real estate, knowing the value of a rental property is essential to avoid overpaying for a home or to know when to move fast when the right deal comes along.
We’ll discuss the important difference between gross and adjusted rental income, then learn to calculate property value based on rental income.
- Gross rental income is the amount of rental income collected without accounting for a vacancy allowance.
- Adjusted gross rental income considers revenue lost when a property is vacant and waiting for a new tenant.
- The 4 methods used to value rental property are the income/cap rate approach, gross rent multiplier, sales comparison approach, and the multimethod Stessa Valuation Tool.
How gross and adjusted rental income is calculated
Gross rental income is the total amount of money received from a tenant, including the monthly rent, late fees (if any), and miscellaneous income from items such as pet rent, parking, and application fees.
Note that a refundable tenant security deposit is not rental income unless part or all of the deposit is used at some point to pay for damages caused by the tenant.
When analyzing a rental property to purchase or refinance, investors use a metric known as “adjusted rental income.” Adjusted rental income factors in a vacancy allowance to account for rental income lost between periods of tenant turnover because rental property typically isn’t rented 100% of the time, year after year, without any vacancy days.
The following example illustrates how to calculate gross rental income and adjusted rental income on an annual basis:
- 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%. In other words, we assume that the property is vacant for about 18 days each year (365 days x 5%) and then subtract 18 days of lost rental income from the total gross rental income.
However, 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.
4 ways to calculate property value based on rental income
Let’s look at 4 ways to calculate property value based on income. Some of the following methods use adjusted gross rental income, while others use gross rental income to calculate property value.
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.
Stessa calculates property market values and return metrics in real time based on key variables. The default valuation method provides an estimated market value Zestimate, based on Zillow’s proprietary formula.
Stessa users can also switch valuation methods with just one click. Other valuation methods are the income/cap rate approach and the gross rent multiplier (GRM) valuation method, described below.
Regardless of which valuation method is used, the property value is updated automatically in Stessa on the real estate balance sheet to provide an investor with a more accurate idea of the owner’s equity.
2. Income/cap rate approach
The income approach formula values a rental property based on net operating income and cap rate, or capitalization rate. Net operating income (NOI) is calculated by subtracting operating expenses from adjusted gross rental income, while cap rate is calculated by dividing NOI by property or purchase price:
- Cap rate = NOI / property value or purchase price
An investor may determine operating expenses based on a specific property’s historical and anticipated future expenses, or use the 50% Rule if a property has never been rented before.
The 50% Rule estimates what operating expenses are likely to be by multiplying the adjusted gross rental income by 50%. For example, if adjusted gross rental income is $17,670, operating expenses should be no more than $8,835, and the NOI should be at least $8,835.
Note that NOI does not include any mortgage payment, contributions to a capital expense (CapEx) account, or the non-cash depreciation expense.
Here’s an example of how to use the income approach to calculate property value. We’ll assume that similar rental properties in the same area are trading for a cap rate of 6%.
The first step is to calculate NOI by subtracting operating expenses from adjusted rental income:
- Adjusted gross rental income: $17,670
- Operating expenses: $7,950
- NOI: $9,720
Then, the cap rate formula is rearranged to solve for 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 to calculate property value uses gross rental income without factoring in operating expenses. While GRM is arguably a simplistic way of determining property value, it is also a good “back-of-the-envelope” way to ballpark property value based on gross rental income.
GRM is based on the concept that the more gross rental income a property generates relative to the purchase price, the better value the property may be, everything else being equal. 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 GRM of 8.7 means the rental property will generate rental income equal to the property value in 8.7 years, assuming the amount of rental income doesn’t change.
As a rule of thumb, a rental property with a lower GRM compared to similar rental properties in the same area may be a better value. That’s because the lower the GRM, the more gross rental income generated relative to the purchase price.
GRM also can be used to calculate rental property value based on rental income by rearranging the GRM formula. To illustrate, assume that GRMs for similar rental properties in an area are 8.7. If gross rental income is $18,600, 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
Also known simply as “comps,” the sales comparison approach looks at similar properties in the same area that have recently sold. The property being valued is called the “subject property,” and the comparison properties are called “comparables.”
Here’s an example of how potential buyers can value a rental property using the sales comparison. If a comparable has a better feature than the subject property, such as an extra bathroom, the value of the comparable is adjusted downward, and vice versa:
|Subject||Comp #1||Comp #2||Comp #3|
|Garage||No||Yes; -$2,000||No||Yes; -$2,000|
After valuing a property using the sales comparison approach, it’s important to look at the property’s gross rental income and operating expenses.
Investors should consider factors, such as rent prices of comparable properties in the same area and actual or projected operating expenses. For example, even though the subject property has a higher price per square foot, it may be near amenities, such as a park or school, that could justify a higher asking rent and a greater potential return on investment (ROI).