How to assess the value of an income property

Even today, real estate represents a safe and profitable investment. Nevertheless, the purchase of an income property, whether large or small, remains an undertaking that must be carefully considered.

Buying or selling a rental property represents a significant real estate transaction. As a buyer, but also as a seller, it is important to have the value of the property assessed by a professional. Keep reading to find out how and why.

Assessing the Market Value of an Income Property

Depending on the number of units and the type of property, there are two methods that can be used to assess the market value of a property: the sales comparison approach and the income approach. For small rental buildings, it is possible to combine these two approaches.

The Sales Comparison Approach

This approach allows a quick assessment of the market value of small buildings (less than 6 dwellings). As the name suggests, it consists of comparing the price and characteristics of the property for sale with those of similar buildings (between 3 and 10) recently sold in the neighbourhood. Here are some criteria that can be compared:

• The number of floors;
• The number of rooms (bedrooms and bathrooms in particular);
• Surface area (of the house itself and the land);
• Amenities (e.g., basement, terrace, garage, etc.).

The sales comparison approach is used by both real estate brokers and licensed appraisers.

The Income Approach

With this approach, the market value of a rental property is measured based on the net income it generates, compared to real estate market data. This analysis requires an advanced knowledge of financial mathematics. It is therefore more commonly used to calculate the value of large buildings.

For these calculations, the appraiser takes into account: the amount of rent, expenses, the vacancy rate, bad debts, etc. This appraisal results in a report given to the client.

Ratios Used to Assess the Value of a Rental Property

When it comes to assessing the market value of a rental property, it is interesting to analyze the following ratios:

• Selling price per square foot = selling price/living area
• Selling price per unit = selling price/number of units
• Selling price per apartment = selling price/number of apartments

However, these are not the only calculations upon which a professional appraiser may base their estimate.

In fact, there are three other indicators that are essential to provide a complete evaluation, based on ratios between the income generated by a building and its selling price.

1. The Gross Income Multiplier (GIM)

The Gross Income Multiplier is one of the few basic concepts that can be useful to master before embarking on a real estate investment. It can be calculated using the following formula: selling price/gross income of the building.

It allows us to compare recently sold buildings in the neighbourhood and thus determine an average GIM. From this average, we can then calculate whether a selling price is in line with market prices.

2. The Net Income Multiplier (NIM)

The calculation of the Net Income Multiplier is similar to that of the Gross Income Multiplier. The only difference, as you may have already guessed, is that it is calculated on the basis of the net income, i.e., the selling price/net income of the property.

To calculate the net income, various expenses must be deducted from the gross income, such as building management and maintenance fees, insurance, municipal taxes, etc. Mortgage payments, however, are not deducted from this income.

The Net Income Multiplier is used to assess the profitability of an income property. The ideal NIM lies between 10 and 16.

3. The Discount Rate (DR - or the Cap Rate)

The Discount Rate is used to measure the performance of a building and the expected return on the investment.

Unlike the NIM, this time we must divide the net income by the selling price. And since we are calculating a rate, the result must be multiplied by 100.

Example:

Net income $35,000 and selling price $415,000

DR = (35,000/ 415,000) x 100 = 8.43 (net income/selling price) x 100

The higher the DR, the better the net income/selling price ratio.

Factors that Influence the Value of an Income Property

Other factors can also impact the market value and profitability of a multiplex. The following must also be taken into consideration before purchasing a property:

• Location — is the neighbourhood safe? what services are nearby? what is its development potential?
• Demand — is this a coveted sector?
• Rents — what are the rents and vacancy rates in the neighbourhood (or even in the building)?
• Tenants — have the tenants been residents for a long time? are rents paid on time? how long are the leases?
• The status of the building — is there a manager? what are the maintenance costs? But above all, as with any real estate purchase, it is important to have the building inspected by a professional in order to prevent any unpleasant surprises.

Beyond the market value of the building, you must be attentive to what this investment will bring you. To analyze the profitability of a building, a simple solution is to calculate the Debt Coverage Ratio (DCR).

This is the ratio between the expenses and the annual income related to the rental property (income/expenses). The minimum acceptable threshold is reached when the revenues generated represent 125% of the expenses.

Do you want to increase the value of your building? There are several strategies to optimize the value of your properties.

Why Value a Rental Property?

As with all types of properties, market value appraisals are particularly useful when a sale is anticipated. It will help the seller to determine the selling price.

In addition to this, the seller will have a report from their certified appraiser that they can present to potential buyers. Having the value of a property appraised, provided the seller has not already done so, will not only ensure that you pay the right price, but will also help you to complete your mortgage application.

The valuation of an income property is also of interest to the owner. In doing this, they can obtain an accurate idea of the amount of equity held. This information can be essential for tax purposes or for borrowing against the equity in your home.

What about the municipal assessment?

Having an income property appraised is a cost you could probably do without. It may be tempting to rely solely on the value indicated on your municipal taxes, but this would be a very bad idea! To understand why, check out our article Market Value and the Municipal Assessment.

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