Valuing Real Estate – The Rental Income Approach

January 24, 2012 in Real Estate


Last week, I discussed the major benefits of using rental income as a basis to determine the long-term true value of real estate.  The rental income approach avoids the short-term focus of traditional sales comp based valuations.  In addition, the rental income valuations have historically been more stable and far more immune to boom and bust cycles like the one that has rocked real estate prices over the last several years.  This week, I will go into the specific details of exactly how to utilize the rental income approach to determine a property’s valuation.

Buying vs. Renting

Preparing the rental income valuation involves using the current rental rates as a guide for how much local residents are willing and able to pay on a monthly basis for a particular property.  Therefore you must start by determining the market rental rate for the particular property that you are analyzing.  If you do not have experience investing in a particular area you can research similar, nearby homes listed for rent, in order to estimate the current market rental rate.  Once you have determined the annual amount that renters are currently paying for similar properties, you must adjust this number for the additional costs of homeownership including:

-          Property Taxes:  This is a major component of the cost of owning a home.  Information on city and county property taxes are publically available in most areas.    Be sure to verify that the current taxes will not rise significantly upon a change of ownership.  Also consider that many areas offer discounts for owner-occupants that are not available for landlords.

-          Insurance:  You can consult with a local insurance agent for this figure, which will vary by property size, type, and location.

-          Annual Maintenance Costs:  This is an estimate of the cost of maintaining a property.  Each year the property will likely require minor repairs and every few years it may be necessary to repair a major system or structure such as the roof, heating & cooling system, or plumbing.  The annual maintenance estimate should easily exceed the average annual cost of minor repairs in anticipation of larger, but less frequent major repairs.  In our analysis we typically use $1,000-$1,500/year.  Your estimate may vary based on the age of the systems and structures of the home along with the typical, local costs of making various repairs.

Once you have subtracted these three costs from the annual rental amount, what is left can go towards the monthly mortgage payment.  In order to determine the sales price that a homebuyer could afford to pay based on their rental budget, it is now necessary to make some assumptions about financing terms.  The mortgage market will likely stabilize in the coming years as the decline in property values slows.  However, given the current state of the mortgage market it is important to be particularly conservative in making these assumptions.

-          Mortgage Rates:  This figure has a significant impact on the valuation so I would recommend that conservative investors add a considerable cushion to today’s historically low rates.  I typically use a 10% interest rate.  In this analysis you will want to use amortized monthly payments that include interest and principle.

-          Required Down Payment:  This figure measures the amount that lenders will require borrowers to put down as a percentage of the sales price.  Currently lenders are requiring 3.5-20% down for owner-occupants.  I assume a 10% required down payment, which is fairly conservative based on the government’s commitment to continue to offer low down payment loan programs.

-          Cost of Down Payment:  Typically buyers have to put up a larger down payment to purchase a home than they would to rent.   I recommend taking the cost of this extra burden into account.  If a buyer has to put down $4,000 to purchase a home, but would only need $1,500 to move into a similar rental property, I would assume the buyer had to borrow the additional $2,500 at an interest rate of one to two times the assumed mortgage rate.  In my analysis I use a 20% rate, which is the equivalent of the buyer using a credit card for the extra money.

With assumptions made for each of these inputs, you can now determine the maximum purchase price that a buyer would be able to pay while spending no more than their current rental budget.

The Rental Income Approach in Action

In order to better clarify exactly how to walk through each of these valuation steps, here is a property in metro Detroit that we recently analyzed.  This particular property is a 4 bedroom, 2.5 bathroom home in Southfield, MI that will currently rent for at least $1,500 per month or $18,000 per year

-          Property Taxes:  $6,379/yr

-          Insurance:  $1,500/yr

-          Annual Maintenance Costs:  $1,500/yr

After subtracting those three ownership expenses there is $8,621 per year or $718.42 per month left to go towards financing the purchase price.  As stated above, I make the following assumptions about the mortgage market:

-          Mortgage Rates:  10% Annual Interest Rate

-          Required Down Payment:  10% Down

-          Cost of Additional Down Payment:  20% Annual Interest Rate

-          Other Mortgage Terms:  Assumes 30yr Fully Amortizing Loan

With a spreadsheet you can now calculate the maximum purchase price that would keep a potential homebuyer’s ownership costs at or below their rental costs.  (If you would like a copy of the customizable Excel form that I use, please feel free to request it by email).  Under these assumptions you will find that a buyer could pay $80,000 for this particular property without going beyond their current rental budget. (I typically round down to the nearest thousand)

-          Loan Amount:  $72,000

-          Annual Mortgage Payments:  $7,582/yr

-          Cost of Additional Down Payment:  $1,000/yr (Additional down payment: $8,000 – $3,000 = $5,000)

Annual Rental Costs: $18,000


Annual Ownership Costs:  $17,961

Garbage In – Garbage Out

It is important to remember when doing any valuation analysis that the results are only as good as the assumptions that you make.  In this rental income analysis, for example, determining an accurate market rental rate is particularly important to get reliable results.  If you are new to real estate investing or analyzing an area for the first time, a knowledgeable broker or seasoned local investor can help in completing this analysis.  Even then, be sure to still ask about the supporting data they are using to make their assumptions.  Your confidence in the inputs that you use for this analysis will also play a big factor in determining the size of your margin of safety, which I have discussed briefly in previous articles and will go into more detail on in the future.

So You Have The Rental Income Valuation – Now What?

Determining the rental income valuation is a great start to determining the attractiveness of a potential real estate investment.  You now have an idea of where the value for this property should ultimately end up and therefore a sense of the property’s appreciation potential.  The next step is to do a cash flow analysis to be sure that the property meets your annual cash profit goals.  You can then combine the appreciation potential with the annual cash flow potential to determine if the property appears to be an attractive investment and at what price.  Finally, you can use the sales comp approach to supplement your analysis and ensure that there are no similar investment properties available at an even lower price.

Over the next few weeks, I will continue to walk through these steps for successfully analyzing investment properties.  If you would like further information on available investment opportunities in the metro Detroit area or would like to discuss a potential real estate investment in your local market, feel free to contact us for additional information.

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