Real Estate Appraisal for Rental Properties

By Steve Gillman - 2005

Real estate appraisal for rental properties is different than that for single family homes. When looking at a 24-unit building, it would be difficult to find similar ones nearby that have recently sold. This is why a market analysis using comparable sales isn't normally used.

It's also not very useful to use replacement costs either. How can you figure replacement cost if there's no longer any land for sale nearby with proper zoning? This can be used as a secondary method, though, and it can tell you if maybe you SHOULD be building instead of buying.

Real Estate Appraisal Using Capitalization

Investors buy rental properties for the income they produce, and therefore it is income that is used to determine value. The rate of return expected by investors in a given area gives you the capitalization rate. This is what you use to accurately appraise an income property.

First, start with the gross income. Then subtract all expenses, but not loan payments. If the building's gross income is $82,000 per year, and the expenses are $30,000, you have a net before debt-service of $52,000. Now you apply the capitalization rate to this figure.

If the usual capitalization rate is .10, for example (ask a real estate professional), divide the income of $52,000 by .10, and you get $520,000. This gives you the value of the building. If the common rate is .08, meaning investors in the area expect only an 8% return, the value would be $650,000.

Simple Real Estate Appraisal?

Take net income before debt-service, and divide by the "cap rate:" This really is a simple formula, but the tough part is getting accurate income figures. Be sure the seller is showing you ALL the normal expenses, and not exaggerating income. If he has stopped repairing things for a year, and is showing "projected" rents, instead of actual rents collected, the income figure could be $15,000 too high. This would mean the appraisal shows the building is worth $187,000 more (.08 cap rate) than it's real value.

One thing smart investors do when buying, is to separate out income from vending machines and laundry machines. If these sources provide $6,000 of the income, that would add $75,000 to the appraised value (.08 cap rate). First do the appraisal without this income included, then add back the replacement cost of the machines (probably much less than $75,000).

Always be careful when you use any real estate appraisal method. No appraisal formula is perfect, and all are only as good as the figures you plug into them. When used carefully, though, real estate appraisal using capitalization rates is the most accurate method for rental properties.

If the above explanation of real estate appraisal using capitalization rates was helpful, you may also want to read... Buying Rental Properties - What to Look For

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