Acquiring a rental property is an excellent way to generate wealth, but only when you know how to evaluate properties and choose the right one. It is a decision that should not be taken lightly, especially if it is your first property— after all, investing in real estate is a risk, but information can greatly improve your odds of success.
Determining the return on investment is as important as determining its value when analyzing the profitability of a project. Here are three methods you can use to appraise a rental property.
1. Sales Comparison Approach
The Sales Comparison Approach (SCA) is one of the simplest methods you can apply. It involves comparing the value of similar properties that have been sold or rented in the area over a given time.
To estimate the value of a property using the SCA, you will have to rely on common characteristics, such as the price per square meter or the number of bedrooms. Other elements, such as terraces, swimming pools, or fireplaces, will serve as a reference to establish the value of your particular property.
The problem with the SCA is that it makes it somewhat complicated to appraise unique properties. Think of it as a benchmark instead of a prediction of a property’s value. However, we strongly recommend that you analyze it over an extended period to understand price patterns and identify investment opportunities.
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2. Capital Asset Pricing Model (CAPM)
The CAPM is one of the most comprehensive valuation tools, as it considers the risks of rental property and opportunity costs when valuing a property.
This model compares the potential return on investment (ROI) of rental income to risk-free investments, such as U.S. Treasury bonds or Real Estate Investment Trusts. If the ROI of a risk-free investment is higher than that of a property, you should stay away from it. Some risk factors to consider are maintenance costs, security measures, vacancy, lack of liquidity, and debt-to-equity ratio.
If you have already decided on a property and would like to have the help of a team of professionals to help you manage it and reduce many of these risks, contact us!
3. Income Approach
The income approach studies the relationship between the potential return on rental property and the initial investment. To calculate it, you need to project an annual estimate by dividing the gross annual rent by the value of the property. For example, if a property costs $100,000 and its projected monthly income is $1,300, the projected annual capitalization rate is: $15,600 ($1,300 x 12 months) ÷ $100,000 = $0.156 or 15.6%.
Note that this model does not account for other factors, such as mortgage interest or rental price variability. In addition, dollars received in the future are subject to the risk of inflation and deflation. All of this makes it difficult to make an accurate projection.
As you can see, there are many different ways to determine the value of a property. The most important thing is to pay attention to market changes and gather as much data as possible before making a decision.
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