Basics of Real Estate Valuation for Rental Properties

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Real Estate is one of the largest asset classes in the world, worth hundreds of trillions of dollars globally. Behind every occupied apartment unit is a leasing strategy designed to turn space into long-term profit.

These are the topics that will be covered below:

• Perceived Real Estate Terminology
• Income Statement Drivers
• Real Estate Valuation Methods

Foundation of Value

The concepts below will explain how value is perceived differently by the market, investors, and actual transactions.

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What is Real Estate?

Real estate is a physical asset consisting of land, property, or improvements permanently attached to it.

Some common examples, as you know, are: houses, apartment buildings, offices, malls, warehouses, hotels, and other things.

Market Value

Market value is the most probable selling price under normal market conditions for a typical buyer. Therefore, the price is deemed suitable for rational buyers.

Typical traits and conditions of a rational buyer are:

• Reasonable mortgage interest rates exist for buyers
• Buyers have enough time to compare properties
• Buyers live in a stable economic environment
• Normal Supply and Demand exist for buyers and sellers

It’s always important, as a buyer, to compare properties and secure a reasonable line of financing when buying. As for sellers its important to know the demographics of the buyers and evaluate if your price is similar to other comparable properties.

Investment Value

Investment value is the value tailored to a specific investor’s financial goals and needs. Every Investor has their own return requirements, tax situations, risk tolerance, strategies, and business goals.

Transaction Price

Transaction Price is the historical value of a purchase or exchange of a property. Real estate appraisers use these transaction prices as comparable properties, then adjust the value based on a variety of factors listed below:

• size
• age
• quality
• ammenities
• location

Market Rent

Market rent is the most probable rental rate under normal leasing conditions.

Market rent is pretty much the same thing as market value, explained above. The only difference is that this market value is specifically tied to rental properties.

Contract Rent

Contract rent is the amount of income the owner expects to receive from the people who agreed to lease the owner’s property. Owners use the contract rent as a base to calculate their income statement.

The next section will cover how income and risk determine real estate value.

Net Operating Income & Property Income

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Potential Gross Income

The maximum amount of income if the owner assumes the property is fully leased out. This is important to get a good idea of how much maximum revenue you can generate.

Vacancy & Collection Loss

This is any future income lost because either the property wasn’t fully leased out, or if the tenant did not pay. Real estate analysts use an estimation to calculate their effective gross income.

Effective Gross Income

Effective gross income is the income remaining after vacancy and collection losses have been subtracted. Many analysts view this as their “net revenue”.

Operating Expenses

Operating expenses are expenses incurred to operate the property. Operating expenses tend to be around 35–45% of effective gross income.

Common examples are:

• property taxes
• insurance
• payroll
• utilities
• cleaning
• repairs and maintenace

Capital Expenses

Now, capital expenses are major costs used to improve, replace, or extend the life of property. These expenses are larger, infrequent, and long maintenance term investments.

Common examples are:

• replacing roof
• installing HVAC
• Major renovations

Net Operating Income

Effective gross income minus (operating expenses+capital expenses).

Net Operating Income is important because it’s the income that is used for direct and yield capitalization.

After covering perceived real estate values, income approaches, and income statement line items, the next section will cover the development of real estate.

Income Approach & Valuation

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Income Capitalization Approach

This first concept explains real estate values based on the present value of future income.

The words “present value of future income” refer to how money in the future is worth less than money today because of inflation, other options to reinvest, or if the future income has risk.

Direct Capitalization

Direct capitalization is a method that converts one year of income into a value using a cap rate.

A cap rate (capitalization rate) is the expected return an investor receives from a property, based on its income and price.

Basically, the idea is that if investors require a certain rate of return, how much would they pay today for this continual annual stream?

Source: HelloData.ai

Yield Capitalization

Yield capitalization is a valuation method that estimates a property’s value by analyzing all expected future cash flows over time and discounting them back to present value.

While direct capitalization looks at only one year of income, yield capitalization looks at more than 1 year, which makes yield capitalization slightly more complex.

Yield capitalization looks at:

• multiple years of income
• rent growth year to year
• % of vacancy if there are multiple units/properties
• expense growth
• changing market conditions

Source: Study.Com

The P1 would represent the income generated for the first year, the r would represent the discount rate explained right below this.

Discount Rate

The discount rate is the required rate of return an investor uses to convert future cash flows to today’s value. The discount rate reflects the risk, opportunity cost, inflation, and the reward investors expect for investing their money.

Reversion

A reversion is the estimated value an investor expects to receive when the property is sold after owning it for x number of years.

To calculate the reversion, it is the most recent income before the time of sale divided by the cap rate.

Source: Hello Data

Conclusion

This article has discussed the common real estate concepts, how to get net operating income, and how to value real estate by using the operating income.

Many people typically use these calculations to either rent out their own property or rent out huge apartment buildings.

Thank you for reading this article. I hope you have found this useful!