Real estate remains a safe and profitable investment event today. However, purchasing an income property, whether large or small, is still a decision that requires careful consideration.
Buying or selling a rental property is a significant real estate transaction. As both a buyer and a seller, it is essential to have the property’s value assessed by a professional. Read on to find out why and how.
Market value vs. economic value: what’s the difference?
The difference between these two values largely depends on the context in which they are used and the factors involved in measuring them.
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Market value refers to the price a buyer is willing to pay for a property in a free and competitive market at a specific point in time. This value is primarily influenced by the laws of supply and demand.
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Economic value, however, considers various financial factors such as the capitalization rate or income multiplier to establish a rational value for the property. Financial institutions often rely on this value to determine the amount of financing they are willing to provide.
In some cases, market value may exceed economic value, particularly during bidding wars. On the other hand, in less desirable locations, market value could be lower than economic value.
A certified appraiser can assess both market and economic values during their property evaluations.
How to assess the price of an income property?
The market value of an income property can be assessed using two methods, depending on the property type and number of units: the sale comparison method and the income method. For smaller rental building, these two methods can be combined.
The sale comparison method
This approach provides a quick way to assess the market value of small buildings (fewer than 6 units). As the name suggests, it involves comparing the price and features of the property for sale with those of similar buildings (typically between 3 and 10) that have recently sold in the area. Some of the criteria that can be compared include:
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The number of floors
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The number of rooms (especially bedrooms and bathrooms)
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The surface area (both the house itself and the land)
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The amenities such as a basement, terrace, garage, etc.
The sale comparison method is commonly used by both real estate brokers and certified appraisers.
The income method
This approach determines the market value of a rental property based on the net income it generates, using real estate market data for comparison. It requires a solid understanding of financial mathematics and is therefore more commonly used for valuing larger buildings.
To perform this assessment, the appraiser considers factors such as the rent amount, expenses, vacancy rate, bad debts, and other relevant financial details. The result is a detailed appraisal report provided to the client.
The 3 ratios used to assess the value of a rental property
When assessing the market value of a rental property, it is useful to analyze the following ratios:
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Selling price per square foot = selling price/living area
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Selling price per unit = selling price/number of units
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Selling price per apartment = selling price/number of apartments
However, these are not the only calculations upon which a professional appraiser may rely on. In fact, there are three additional key indicators, based on ratios between the income generated by a property and its selling price, that are essential for providing a comprehensive evaluation.
1. The Gross Income Multiplier (GIM)
The Gross Income Multiplier is a fundamental concept to understand before making a real estate investment. It is calculated using the following formula:
GIM = selling price / gross income of the building
This ratio allows for a comparison of recently sold properties in the neighbourhood, helping to establish an average GIM. By comparing the GIM of a specific property to this average, you can assess whether its selling price aligns with current market values.
2. The Net Income Multiplier (NIM)
The calculation of the Net Income Multiplier is similar to that of the Gross Income Multiplier, with one key difference: it is based on net income rather than gross income. The formula is:
NIM = selling price / net income of the property
To calculate the net income, various expenses must be deducted from the gross income, including building management and maintenance fees, insurance, municipal taxes, etc. However, mortgage payments are not deducted from the net income.
The Net Income Multiplier is used to assess the profitability of an income property. An ideal NIM typically falls between 10 and 16.
3. The Discount Rate (DR - or the Cap Rate)
The Discount Rate, also known as the Capitalization Rate (Cap Rate), is used to measure the performance of a property and the expected return on investment.
Unlike the NIM, the Discount Rate is calculated by dividing the net income by the selling price, and then multiplying the result by 100 to express it as a percentage.
Example:
Net income = $35,000
Selling price = $415,000
DR = (35,000 / 415,000) × 100 = 8.43%
The higher the DR, the better the ratio of net income to selling price, indicating a more favourable investment.
Factors that influence the value of an income property
Several factors can affect the market value and profitability of a multiplex. These elements should also be carefully considered before purchasing a property:
- Location
- Is the neighbourhood safe?
- What services and amenities are nearby?
- What is the property’s development potential?
- Demand
- Is this area in high demand or highly sought after?
- Rents
- What are the average rent amount and vacancy rates in the neighbourhood (or even within the building itself)?
- Tenants
- Have the tenants been long-term residents?
- Are rents paid on time?
- What is the length of the leases?
- The condition of the building
- Is there a property manager?
- What are the maintenance and repair costs?
- Has a professional building inspection been conducted to avoid any unpleasant surprises?
Beyond the market value of the building, it’s important to assess what this investment will yield in terms of profitability. A simple way to analyze the profitability of a property is by calculating the Debt Coverage Ratio (DCR).
The DCR is the ratio between the annual income and the expenses related to the rental property (income / expenses). The minimum acceptable threshold is typically considered to be when the revenues generated represent 125% of the expenses.
Why value a rental property?
As with all types of properties, market value appraisals are especially useful when a sale is expected. It helps the seller determine an appropriate selling price.
Moreover, having the property appraised provides the seller with a certified report that can be presented to potential buyers. If the seller has not already had the property valued, this appraisal will not only ensure they set the right price but also assist with the mortgage application process.
For the property owner, valuing an income property is also important. It gives them an accurate understanding of the equity they hold in the property, which can be crucial for tax purposes or when considering borrowing against the equity.
What about the municipal assessment?
While having an income property appraised can be an additional cost you might prefer to avoid, it can be tempting to rely solely on the value stated in your municipal assessment. However, this is generally a very bad idea!
Looking for an expert to determine an income property's market value?
XpertSource.com can help you find a certified appraiser. When you tell us about your project, we put you in touch with qualified resources for FREE. Simply fill out our form ( it only takes a few minutes ) and we will connect you with professionals.
