When you're looking at your investment rental property, or you're looking to borrow to possibly invest in a property, you can use four specific tools available to value properties -- prices per square foot or unit, gross rent multipliers, capitalization rates, and internal rates of return. These tools help you understand the value of properties that you own and help you decide whether properties you see are worth buying. Knowing where your rental properties stand also helps you measure your wealth as it grows so that you can track your progress toward meeting your financial goals.
Price Per Pound
"Price per pound" real estate metrics typically come in two flavors -- price per unit, used with apartment buildings and hotels, and price per square foot, which investors use with commercial properties. These allow you to easily compare two relatively similar buildings. If everything else is equal, and one is $90 per square foot and the other is $80 per square foot, buy the $80 one. When you know the market's typical price per pound, use it to estimate the value of the property you are thinking about.
Gross Rent Multiplier
The Gross Rent Multiplier or Gross Income Multiplier values property relative to its income. To calculate it, just divide its price by its rental income. If you have the GRM, you can multiply the rental income by it to find a value. For instance, if you know that properties in your market usually trade at 8 times rent, which is an 8 GRM, and your property generates $50,000 in rent a year, it would have a value of $400,000.
Capitalization rates, as they are usually called, use a property's net operating income after expenses to determine a valuation. To calculate a capitalization rate for a property, divide its net income by its price. As with the GRM model, you can also use a cap rate that you derived from market data to value any property. Just divide the income by the cap rate. Express the cap rate as a decimal, so an 8 percent cap rate is 0.08. Caps are the industry standard for valuation because they take the most information into account, looking at a property's performance on the basis of its income and its expenses.
Internal Rate of Return
Internal rates of return represent the most complicated investment real estate valuation metrics. When you calculate an IRR for a property, you look at every aspect of owning it -- what you pay for it, what you make from it, how your loan works, how you think it will perform in the future, and what you think it will sell for. Running an IRR requires you to project a property's future prospects and project how the market will perform in the future, but if you use the same assumptions, it can really help you compare properties.
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