How to Value Real Estate Rental Properties

I’m a numbers guy. However, when I started looking for rental properties there was one qualitative factor that I considered before any quantitative metrics, location. After the properties were filtered by location I’d filter the list further using cash flow modelling and cap rate. I’ll go over all three of these below:

LOCATION

Now being a numbers guy location has never been something I’ve ever considered when making investment decisions. I own a number of publicly traded REITs (real estate investment trusts) and to be honest I don’t care if they are in good or bad neighborhoods. My only concern on these types of investments is if they make money. These large publicly traded companies have full time employees that handle all the tenant issues, maintenance, insurance, marketing, evictions etc…

My rental won’t be my full time job so I don’t want to spend more time than I have to dealing with tenants and repairs.  As a result, I’ve limited my search to working class neighborhoods. Most of the homes in the areas I was looking at were small but well maintained with clean yards that showed some pride of ownership. My rational is that I didn’t want to own a home in a neighborhood that I wouldn’t be willing to live in.  Right or wrong I don’t want to deal with tenants that are comfortable living in rundown neighborhoods.

CASH FLOW

After figuring out which neighborhoods were suitable the next thing I looked at was the theoretical cash flow of the property. The first step was to scour the apartment rental adds for the area so that I could come up with a reasonable expectation of what I could charge every month for rent.

Then I made a spread sheet with all the monthly expenses:

-Mortgage (amortized over 20yrs)
-Property Taxes
-Condo Fees
-Insurance
-Natural Gas
-Water
-Hydro
-Hot Water Rental
-Repairs

For repairs I used 0.083% of the purchase price (which is 1% annually). So some years it’ll be less and some more.

Once you have all those numbers the math takes care of itself:

CASH FLOW = RENTAL INCOME - EXPENSES

Of course the above cash flow number does not account for any vacancies. So I modeled the cash flow using different occupancy rates ie- 100%, 90%, 80% etc… In order for a property to qualify it had to break even with an occupancy rate of 70%.

CAPITALIZATION RATE

The Cap Rate is the ratio of Net Operating Income (NOI) to property asset value. So basically it’s the net annual rental Income (not including your mortgage) divided by the Value of the Property:

Cap rate = (Rent – insurance –electricity–gas –taxes –water -repairs) / (Asset Value of the House)

Another way to look at it is the annual percent you’d earn off your investment if you were to buy the property in cash.

Unlike cash flow the cap rate is only useful for comparing properties within the same city or neighborhood. For example, if you were investing in the San Francisco area the average cap rate might only be 3% where the average in Taylor Michigan might be more like 8%.  So a decent cap rate in the San Fran area might be 5% but if you were investing in Taylor it might be more like 10%. Comparing the two would be like comparing apples to oranges. If you required a 10% cap rate in San Francisco you would literally never be able to find a property.

In the city I bought my rental the average cap rate is approximately 6% so basically I wouldn’t look at anything with a cap rate under that number. The property I ended up purchasing is estimated to have a cap rate of around 8%.

*If you plan on using cap rate in your own investment decisions don’t forget to include the cost of any property improvements that you plan on doing upon purchase ie-new floor, roof etc...