Need a rental appraisal? How do rental properties get appraised? What are the different ways that they can be appraised? The answer to those questions depends on how big or small your rental property is, as well as what type of investment you have in it. This article will go over the differences between residential rental property and commercial rental property appraisal methods.
1) Residential Rental Property Appraisal Method
First, sometimes residential home appraisals are requested when a homeowner wants to determine if their home is worth more than what they owe on it. If so, they can take out a home equity loan to make major improvements or pay off other loans. Also, an appraisal is needed if the homeowner wants to refinance their mortgage. Since the homeowner is already living in the house, and it’s not an investment property, the appraiser will use comparable properties to help determine how much the homeowner could get for the house if they want to sell it. A home appraisal with renters will be calculated the same way unless the rental property is determined to be a commercial property. In the next section, we’ll discuss how commercial property is different.
2) Commercial Rental Property Appraisal Method
Single family homes (1 unit), duplexes (2 units), triplexes (3 units), and fourplexes (4 units) are all normally considered residential real estate. If a property or complex has more than four units, it is considered commercial real estate. At this point, some type of investment property appraisal is needed. The income capitalization method is most often used to appraise commercial rental properties. It’s a simple formula that uses net income from a rental property over one year, and then applies a rate of return on that amount to determine what it’s worth today. In essence, it’s an estimation of how much a prospective buyer would pay for a stream of future income. Next, let’s see how to calculate it.
3) Income Capitalization Method
As mentioned before, the income capitalization method calculates a property’s worth using net income. Start by dividing net operating income by the capitalization rate (the rate of return) for the area where the property is located. In other words, take all the property’s income from leasing or renting out its space, subtract all expenses but not including loan payments, and divide it by the capitalization rate. The result is the property’s value. Let’s see an example.
Bob has an 8-unit apartment building that rents out each unit at $1,000 a month. The building’s gross income is $96,000 per year, and the expenses are $33,600. The net income before debt-service is $62,400. Now apply the capitalization rate to this figure.
If the common capitalization rate is .10, for example (ask a real estate agent), divide the income of $62,400 by .10, and you get $624,000. This is the value of the building using the income capitalization method for a rental property appraisal.
4) Rental Property Rent Rolls
Rent rolls are often used by commercial appraisers when they assess income-producing properties. A rent roll is essentially a list of properties with property information, units, tenants, current tenant lease details, information about how tenants are paying rent, tenant deposits, total monthly rents collected and owed, and total annual rent collected. It provides a snapshot of accurate rental income being collected.
5) Historical Vacancy Rates
Commercial property has much higher vacancy rates than residential property. As of this year, 2021, the multi-family vacancy rate is expected to be between 5.25% and 5.75%. It is not uncommon for commercial multi-family vacancy to be higher. This explains why commercial appraisal must consider historical occupancy levels when using capitalization methods. Since previous occupancy data isn’t readily available, appraisers must use industry averages in place of past performance. Rent rolls provide this information by showing lease start and end dates for all tenants which gives a picture of rental income stability.
In Conclusion
In a way, real estate appraisal is all about comparing apples to oranges. The income capitalization method used for appraising investment properties is vastly different from that of residential home appraisals. While a house gets its value based on comparable homes in a neighborhood, a rental property derives its value from an income-producing capacity—and it’s not always easy to find comparable investments with which to compare it. If you decide to become a landlord, rental property appraisal is a subject you should become familiar with.
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