After the recession of 2007-2009, the real estate market has significantly changed from purchasing properties to investing in rentals. But how can you evaluate the rental properties from the investment perspective? There are several well-established ways of valuing rental properties from the finance perspective.
Sales Comparison Approach (SCA) is a conventional approach to valuing residential real estate. It represents a simple comparison of similar homes that have sold or rented in a given area over a selected period. It is beneficial to review an SCA over an extended time frame to be able to see any potentially significant trends and pricing patterns.
The SCA assigns a relative price value based on the attributes such as price per square foot. It is a simple metric commonly used by investors to determine their property value. For example, if a building is renting for a certain price per square foot, investors can anticipate a similar rental income from a comparable rental in the area. However, SCA is rather generic; it does not capture the unique characteristics of each property that may carry additional value to the renters and buyers. The SCA is intended to be a reasonable baseline and not an exact valuation tool for real estate. Investors should be aware of fraudulent appraisals and use a certified appraiser or real estate agent to compile a comparative market analysis.
The cost approach to values real estate property solely based on possible uses. The estimate is calculated by adding the land value to the depreciated value of any property improvements, also called "highest and best" use. The cost approach is frequently used to evaluate vacant land and special use properties. Depending on the location the land's best use will vary. The cost approach helps determine that purpose. Best use value can be affected by property zoning, as rezoning can require significant additional costs. The cost approach is also more reliable for newer structures compared older properties.
The income approach is a preferred tool for investing in commercial real estate. It estimates the potential income a rental property can yield on an initial investment and relies on calculating the annual capitalization rate for an investment which equals the gross projected annual income divided by either the original cost or current value of the property. This model is simplified as it doesn't account for mortgage interest expenses or changes in future rental income or the concept of discounted cash flow.
Capital Asset Pricing Model (CAPM) is a more comprehensive valuation tool. It introduces the concepts of investment risk and opportunity cost. The model evaluates potential return on investment (ROI) derived from rental income and compares it to other types of investments that have virtually no risk (i.e. United States Treasury bonds or alternative real estate investments like real estate investment trusts (REITs).)
From the finance perspective, investment in rental property should yield a higher return on investment than a risk-free or guaranteed investment would. The CAPM also considers the inherent risks like location, crime rates in the area and property age. This model suggests including these risk factors in the calculation before making an investment or establishing the price to determine what return is reasonable for a given level of risk.
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If you don't want to spend much time and investment capital on the evaluation and purchasing of property for your business, consider renting a space from Avalon Suites for assistance. Renting conference rooms, individual offices, and having all of the necessary amenities for your staff and clients can be a worthy investment in itself at a much lower cost and time investment.