This is the second method of evaluating a single family rental home. We talked about the first method, Comparative Market Analysis earlier. If you are new to this blog, please read the page on Getting a Mentor first.
When you have an asset that provides you with a stream of income every month (or periodically), there are ways to arrive at a value for that asset. This value may or may not be the simple dollar cost of the asset. For example, if you have a single family rental home that you purchased in perfect condition for $120K and rented it out, its value as an investment may not be exactly $120k. It might be higher or lower. It depends on the amount of income it produces every year.
The approach of using the produced periodic income to arrive at a value for the asset is called the Income Approach. First, let’s talk about the method itself and then we’ll discuss its applicability to our business model, which is, single family rental real estate in the Dallas, Fort Worth, Denton area.
The Income Approach formula is very simple. Take your net operating income and divide that by the market capitalization rate to arrive at the value of your rental home. Now, let’s define the terms:
Net Operating Income (NOI): This is what your income is before your mortgage payment. For example, if you get a rent of $1,500 on a property and the monthly expenses total to $400, then the net operating income is $1,500-$400=$1100*12 months=$13,200 annually. Typical monthly expenses are property taxes, maintenance and insurance. Do not include your mortgage in this calculation. Reason being, whether you have a mortgage or not does not impact the value of the property. Any portion of rent not collected due to vacancy must be deducted from your gross rent or “potential rent” as well. For example, if your property was vacant for one month, or more importantly if it is likely to remain vacant for one month each year, then the monthly rent amount for this calculation must be reduced accordingly. In the above example it would be $1500*11/12 = 1375 and the net operating income would be $1375-$400=$975*12 months=$11,700 annually.
Capitalization Rate (Cap Rate): This is a factor that’s a constant for a given market area. By constant I mean it is a rate at the market level, not computed specifically for your house. This rate varies over time. Look at what comparable properties in your market rents for. Then look at what those properties are selling for. This could be difficult to do if rental properties do not sell in your neighborhood. So you may have to use other comparable properties and arrive at an educated guess for what a given rental in market condition would sell for. Then calculate what average operating expenses are (again leave out mortgage). Arrive at average net operating income in your market. Divide the average NOI by the average sale price for comparable properties and you arrive at the Capitalization Rate. For example, if the average NOI is $1,000*12=$12,000 and the average comparable sale price is $130,000, then the capitalization rate is $12,000/$130,000 = 9.2%. This means that an investor can expect to receive an annual yield of 9.2% in your market area.
Your Subject’s Value: Now, very simply your single family rental home’s value is your NOI divided by your market’s Cap Rate. If your NOI is $975*12 months = $11,700 and your market cap rate is 9.2%, then your property as an investment home is worth $11,700/9.2%=$127K.
In other words, if you invested $127,000 in this rental home, you can expect a return of $11,700 every year which would be a 9.2% rate of return. Again, this is just a method to arrive at a value, not an actual business practice. In real estate, you use leverage – or other people’s money – to invest. I should perhaps write an article on the power of leverage.
Now, that you have understood the concept of the income approach, let’s debate the applicability of this approach to single family rental homes. There’s a concept called “highest and best use“. That is, you appraise the value of something assuming it would be put to its highest and best use. I am going to twist that notion a bit and ask who’s your most likely customer? Value what you are selling based on who’s most likely to buy it. So in our case, this is a single family home. It’s possible that an investor could buy it but in the subdivisions we operate rental homes in, the ratio of rentals to home owners is very low. So it’s more likely that the buyer will want to live in it and not use it as a rental. So I would argue that the income approach to evaluating the value of a single family rental home is minimal.
What if you are operating in a neighborhood where renting is the norm? Well, then there are two things to consider. First, the investment approach makes more sense. Now, here’s the second part: When you sell your investment home to an investor, you are not only selling the asset but you are also selling a stream of income. You are selling the goose that lays the golden egg. So the true value is not just the current value of the asset but also the current value of the stream of income. This assumes you have established a stream of income and are able to demonstrate to the investor buyer that that stream exists. Now compute the property’s value from the buyer’s point of view. The base asset value is not recognizable till the buyer sells the asset down the road. So you have to project a future sale price for the asset and calculate the current value of that projection. Then, to account for the income stream the buyer will enjoy till the asset is sold, calculate the present value of that stream of income. Add the two and you get the current value of the property as a rental.
There are several complications in doing what we have discussed above. First, you need to project a future sale price for your property. Now, do you project that it will sell to a home owner and use the CMA method or that it will sell to an investor and use the income approach? Perhaps you can go by what kind of area – rental/not – it is in and guess the future buyer. Then you have to account for appreciation. You have to know how long the investor buyer will hold it and also need to arrive at some reasonable interest rate applicable to the buyer.
The more projections you have, the less accurate your result is. So, for single family rental real estate in the Dallas, Fort Worth, Denton area I would stick to the CMA approach for the most part.