Episode #13 – How to Value Income Producing Properties (Houses)
Welcome to EarlToms podcast.
Today we’re going to talk about how to value houses that are already occupied with tenants. It’s a little different than what you’re used to, but you’re still going to use a lot of the same online tools to be able to figure out how to value it. So let’s, let’s start with with something that I harp home. It’s not what every investor uses, but it’s actually the correct way. There’s everybody that values houses, tries to sell them uses the cap rate. That’s actually not correct. Understand that every investor throws it out there and says you’ve got a cap rate of 15 2025. That’s not the correct terminology. That’s not the correct formula. Anything that is going to use a cap rate has at least five units. So you need at least a five unit, apartment, mobile home, you name it, to be able to use a cap rate. Everything that is one to four units, uses what’s called as a gross rent multiplier.
So what you’re stating as a cap rate is actually the return on the investment, the ROI. Typically it’s the gross because you haven’t subtracted any type of expenses or reserves anything like you haven’t, you haven’t subtracted the capex of the ROI. So it’s usually the gross in order to actually use a cap rate, an NOI in the cap rate is actually knit. So you’ve, you’ve subtracted all of your capex, your expenses, carrying college reserves, vacancy rates, you’ve done all that. Those. So one of the reasons that you don’t actually use a cap rate with anything under four units is because it swings. So, so high with the vacancy rate, but the occupancy right. So you would just take a house for example, you either have 100% occupancy, or you have a zero percent occupancy. So, to be able to formulate that inside of a cap rate, it would destroy your your formula. If you have, you know, a duplex same time you’re either at 150 or zero. So you have to, to bigger swings to be able to validate that inside the cap rate formula. Understand everybody does it. It’s an accepted terminology in real estate. It’s not right though. So continue to do what everybody else in the business is doing. But I’m Understand what you’re actually stating. Because one thing about real estate is you make representations you don’t ever want anything to come back on. So that’s actually the appraiser and me talking more than the investor. Because everybody in this business calls it a cap rate when it’s not. So if you call it a cap rate, nobody’s gonna say anything to you. I would just prefer you know, what you’re actually stating versus what everyone in the business is stating even though everyone in the business is actually factually incorrect. So when we when we look at income producing properties, what is important to do is the same thing that I mentioned in the how to get a more accurate ARV episode is you need to go and find that old appraisal form the 1004 and mica spreadsheet out of it, just do a template and then you can see there and go through your comps. Or you can go through your own house if you want to. If you don’t want to put comps on it for this one, that’s fine. You need to do that for the sales comparison part but the income approach is not as important. So what what you need to realize is the sales prices with these income producing properties don’t matter. The Zillow values, what things are selling for on Zillow, completely irrelevant, doesn’t matter. Throw it out, forget about it. Don’t use it. What does matter is the income. Now you’re going to have a standard in your area to where people want to buy at, you know, a 1% value based on the rent, they’re going to bought a 20% 15% whatever is the standard for your area, you need to figure that out. That’s what you’re gonna be able to sell these properties for. So you it’s it goes With that, with that same part of the sales comparison side of it, but you’re you’re valuing the rent now, you’re not valuing a sales price. So you have to kind of change the way you’re gonna think about it. But you’re still using the same basic principles to get to that value. So, how you how you start it, you’ve got something that’s super simple, you can go to Zillow, and you can look what things are renting forums L, you do the exact same thing that you would do when you’re when you’re looking for something that’s sold or what’s for sale because you’re looking at your competition. So what’s for sale or for rent is going to wind up being your competition. So in order to to make things move it all they always say everything comes down to price. Same thing for for rent. So you’re going to actually comp rents now versus sales prices. When you go and you look, you might find find one that’s been on Zillow that’s been listed for 150 days. Well, what that tells me is two different things. Either they’ve got it priced too high, or it doesn’t the market doesn’t have the demand to meet that. That that listing, which it always comes back again to price. So if you’ve got a house that’s been on Zillow for 150 days, that’s rented for 1000. But then you’re saying the same thing, a three bedroom, two bath, rented written for 850 and you don’t see anything in those pictures that would validate the extra hundred and $50. It doesn’t, it’s not going to rent you’re going to get a tenant that goes in there that might have the money. probably going to be a desperation rent by the by the investor because they’re just trying to Get a certain rhythm out instead of following the market conditions. So if your cluster, let’s say is around $850, then you’re gonna throw out that thousand dollar rental. And you might have another one that’s sitting over that says, hey, I’ll go rent this one for $700. You do the same thing with this, you throw the slumlord and the greedy investor out. So you’re looking for the pattern for the cluster. What? To be a pattern you have to have more than two. That’s why you have three comps on every appraisal including on a income appraisal, you’re going to have rent comps, on appraisal when you’re when you’re appraising a property that’s already occupied.
So if you’ve got a couple of rentals that are in the 850 range, one might be 825. One might be 875, and other might be 850. That’s fine. So you’re We’re looking at things in a way of that same process that we did with the with the sales comparison ARV. You’re, you’re going up and down that that form. And I’m gonna, I’m gonna show you how to make this super simple for you. What you do with with these rental properties, as you use what’s called as a gross rent multiplier. Now you have two different ways of doing this form. One is on an annualized basis, one is on a monthly basis. So if you go and I’m gonna do it just for easy math, when I give you a value, I’m gonna I’m gonna call it monthly. But in order to do the annualized and that’s what a lot of your institutional investors are going to use instead of the monthly. I don’t know why it’s more complicated, but it is what it is. So to do the to do the annualized, excuse me for some reason JOHN McAfee this morning to do the annual hours do you have the rent, you multiply it times 12. Okay, once you have the rent, then you know, okay if I’ve got $1,000 a month rent, and I multiply that times 12 now I have $1,000 I mean $12,000 annual income on that property. But in order to get the gross rent multiplier, I’m going to take you back to that spreadsheet with with the old appraisal form the 1004. What you need to do on that is condition appeal Bedroom, Bathroom square footage, those could design site all those different things. You need to use the exact same thing that we all used to get graded on when we were when we’re in school. So if if your sight and you always have to bring it to area You’re not saying, Oh, this is a great house, but it’s in a terrible area. You’re not saying this is a terrible house in a great area, you’re not doing that. You’re looking at the area, in general. So what you should do is either look at like a middle school, or high school area. Don’t go Don’t. I mean, if you wanted to, you could, but if you’ve got a lot of rentals, it’s it’s easier to do that. A lot of times when you’re in the lack of MSA in a major city, you can do an elementary schools area, and you’ll have plenty of plenty accounts to choose from. Most times, you know, you’re going to be you’re going to need that distance for a middle school or a high school. So if, like say your condition for the area is a B, use an A, put an ad next to the condition. Let’s say that the The appeal of it, it’s a nice house for the area. use that as a, say 85.
For the area, if it’s if it’s a B, for the area, use it. If it doesn’t quite meet the a standard, that’s when you use 85. You always use five increments. Don’t ever go in and go on this is an 82 no one’s that good. So if you have a true B, use an 80. If you have something that is that it you know is a B, but it’s it could be an A but it’s not using it file. So when you go down, you’ve got your your your bill, your condition, your sight, appeal, bedrooms, bathrooms, square footage, you’ve got all of that, then you’re going to take that that same way that I told you, you had an adjusted value At the bottom of the spreadsheet, now you’re going to have the average of all of them. So you might have 580s 585 290s whatnot. So let’s let’s for argument’s sake, we’re going to, we’re just going to say this is an 85. So when you’re looking at it, you’ve got $1,000. Rent monthly is going to be super simple. It’s 1000 times 85 gives you your income value of $85,000. When you go through on an annualized basis, you’ve got your thousand times 12 months, because that’s going to give you your yearly income. Then you take that 85 and you divide it by 12. And that’s going to give you quote, unquote, your monthly gross rent multiplier is gonna wind up being the exact same number It’s just easier to do it on a monthly basis because really all you’ve got to do is go, Hey, this this house is almost an eight but it’s still a B. So it’s an 85. 1000 times 85 is $85,000 income value.
Super simple, not hard at all.
When you’re, when you’re showing these when you’re trying to get them sold, you present them to the investor with the income value. You’re gonna like you’re not sending over Hey, this Zillow comp is $85,000 and Miss Zillow comp is 110,000 in this Zillow campus 50,000 that’s not what you’re doing, you’re gonna you’re gonna hurt yourself because the only thing that matters to an investor is the income. If an investor is buying a house to rent, then they need to understand what the income value is. Now I know if they’re going to get alone, most of your banks are going to want that sales comparison they’re going to at Zillow when that realtor value, and that’s fine, because your income if you’re if your rent if you’re doing the highest and best use your income value, and your sales value should be close to each other. So if you’ve got an $85,000 income value, you should have 8085 $90,000 sales value. Once if everything is fixed in good condition, it should be close together. If they’re doing something that’s not in the highest and best use, let’s say they’re going to Beverly Hills to try to rent something out. The income is never going to meet the sales. You’ve got $10 million houses over you know Beverly Hills and you’re going to run them for what 1020 $30,000 a month. That’s not going to give you anywhere near the same or similar values. So renting a house and better hills is not the highest and best use. That’s why you see properties in New York that have the the city anyway that have rent control is because the values are so out of hand, because it’s so dense that if somebody came in and you know, they’ve got to spend $50 million to buy this apartment building, but then they can only get 1500 dollars out of each units rent because rent control that makes those cap rates get real low, when in essence, since the the highest and best use is actually to rent those in the city of New York. If you had to pay $50 million for a 10 unit building, but you can only get 1500 most people are not going to do it but it’s a very stable environment because of the rent control. So instead of you know seeing a good cash on cash return in 1520 years It’s gonna take them 50 years New York is a legitimate long term play very few things into your our short term plays. That’s why anytime you see properties Come come up in New York most times, you know, they sell fairly quick but it is in a rage, outrageous amount of cost to actually invest in something in New York with taxes and all the things, the codes that you’ve got to it’s if you’re in New York, I’m feel sorry for how you have to invest up there but you know that that’s the market of New York. It makes it makes investors money. But at the same time, if you’re going to rent something, go to an investor friendly area, to where there’s not a lot of restrictions on you that you can pretty well do what you want to do that your your expenses are not they’re going to be affordable and Not necessarily outrageous, I guess. But if if you if you’re looking at, at a property that, like I said is has $1,000 rent in there, but you know everything is is pretty well fixed, it’s in good condition, good st for the area, things like that. And you can put a, you know, a solid B on it, the now you’ve got an $85,000 value out of it, because again, 1000 times 85 is 85,000. If you’re gonna go back over this again that the annualized portion of it is 1000 times 12. Your gross rent multiplier that you that you worked out on that spreadsheet is 85 divided by 12. So you might wind up having 12,000 times 6.75 I mean, I don’t know that that’s the annualized off the top of my head, but that might be what it is. So you’re gonna come to the same value either way. When you’re looking at rentals, especially houses, the the most important thing typically is the bedrooms. Bathrooms are important but the bedrooms are usually what drives the rent the amount of it if you know it’s a minute super simple it follows the same thing as a sales comparison a two bedroom typically sells for less than a three bedroom if all things are equal. So if you look at what a two bedroom rents for versus what a three bedroom rent rents for, it’s gonna be the same. Now, two bedrooms are hard in sales and income. If it’s a house anyway, because it’s a it’s a starter. So a lot of times his family grows and things like that they turn over more often, but you’ll always you’ll always rent a two bedroom for more per foot.
Then you’ll rent a three bedroom or a two bedroom and the reason that is is Because it’s the same principle, where you have a lot is worth $50,000. And a price per acre is you’re sitting down and you’ve got a $20,000 per acre, but you’ve only got a 30,000 square foot lot that’s 50,000. So the smaller the property is, is always more per foot than anything else. So don’t worry about what what things are necessarily selling for around and around where your your property is. You have to figure out the what everybody calls a cap, but it’s really a retired, what’s the acceptable return for, you know, a certain market. So, if it’s a 20% return, then that means that the equity for the investor is already built in. If it’s a 15% return, that means that equity is getting is getting skinnier but it is built in. If you’re gonna add a 1% rule you don’t really have a lot of equity because you’re just buying the B or A there are areas that that have this and you know good for them but then took them a long time to make money off of the the easiest way to actually make long term money with rentals is gonna be so I’m gonna say something that is that is probably going to allow lot of people are gonna disagree with it. And when they disagree with it, that’s fine. That’s their way. But if you want to make money long term in real estate with Reynolds, you knew it was section eight. section eight is economy proof. I don’t have a single rental. That is not vaccinate, not on hold. I don’t own a single one that is not section eight. One reason is, is I used to I was the appraiser that the Housing Authority awarded the contract two years ago with their ownership program. So I learned the system a lot better than most people were able to. I liked it. And that’s, you know, what I decided to do. But the main reason is, it’s economy proof. And what I mean by Academy proof is you look at what’s going on right now in the world. People are talking about rent strikes, landlords not being able to pay their mortgage payments, things like that. I have not a single one of my tenants has missed rent or said a word about it during every bit of this.
So while other landlords are out there wondering if their tenants are going to hold their jobs, keep their jobs, be able to make payments or they’re going to have trouble out of their tenants can the victim can make Through all this hassle, my rentals are operating 100% as normal, regardless of circumstances. It is economy proof. So people say that it’s a it’s a war zone. It’s this and that. Some markets on maybe turn, but you need to understand something. The housing authority is a federal program. Someone could be approved for a voucher for rent assistance in New York City and decide that they wanted to move to Los Angeles. The only thing that they have to do is get Los Angeles to agree to pick up their voucher, and they can move. It is completely transferable nationwide. So if you’re say you’re approved in New York City, but you want to live in one of the suburbs of New York instead of the city. That’s That’s fine. It still falls in their district. So they’re still going to pay it. So if you have somebody that’s approved and doesn’t mean if you get into better schools, better areas, those kind of things that section eight is not a viable option. Every single house, every single property in the United States of America, that is residential is section eight approved, if you put it to the code of what they require in section eight requires Fannie Mae, FHA. So if you can pass an FHA inspection, you can rent that property section, it doesn’t matter where it’s at anywhere in the United States. So you don’t have to be in quote unquote, a warzone. To be able to rent section eight and protect your investment. You can go to the good schools, good neighborhoods, good areas, you can do that now are your neighbors gonna appreciate the fact that you did that? Probably not. But your livelihood is what you’re looking out for. So as long as that tenants not causing problems doesn’t matter. Everybody deserves the ability to be empowered, have a chance at something. So if you have a property and you’re going to get $1,000 rent out of it one way or the other, every single time, I would say go Section A, instead of going with somebody with a job because of a Coronavirus, a recession, anything like a foreclosure crisis shows up again, you’re still going to get your rent when everybody else is going to be holding the bag and getting and getting in trouble. So don’t ever think that just because you’re in a certain area that you cannot rent that to someone on section eight, anywhere in the United States, any residential property can be approved for Section A, it does not matter. So that’s why I do it because I protect myself. I don’t have to worry about economic conditions that go on things that are outside of my control. I’m protecting myself. So if you know the Housing Authority is gonna pay you the same thing as what market rent is, protect yourself, let someone its own section eight rent it nine times out of 10 they’re not gonna call you near as often as someone not only as long as you take care of that property and you treat that person, like an actual person of equal value to you.
Now, if you treat them like they’re less, you could potentially have some problems. But I think that is a is something that we all experience in life in general, you treat people as though you want to be treated and everything works out. If If you have any questions on how to value the, the income producing properties, feel free to to leave a comment. Visit us at EarlToms.com, you’ll be able to find some more information that’ll help you grow your business. There. And just for reiteration, the formula to determine income annualized rent times 12 plus times gross rent multiplier divided by 12. And that’ll give you your income, annualized. So it’s rent times 12 times gross rent multiplier divided by 12. You need to put rent, times 12, and a bracket. Gross rent multiplier divided by 12. And a bracket, when you get those two values is when you multiply them together. It’s not a go. It’s not a multiplies, you go to do it monthly. It’s rent times the gross rent multiplier. So it’s the example 1000 times 85. Super simple, not complicated. Everyone should be able to do it. Just go Come rent versus sales price. If, again, if you’ve got any questions or want to leave a comment that’s that’s great. You can you can do that. But don’t forget to go check out EarlToms.com and we should have some things over there that that will help your business grow and maybe some things you hadn’t thought of whether it be business tools, marketing, whatnot. We have we have some things over there. Hope everyone is staying safe with what’s going on everyone’s you know still understanding there is money to be made people people need our help right now. But with that, I’m gonna I’m gonna draw it to a close. We hope you enjoyed this episode. Hope you learned something. We will see you next time. Stay safe everybody. Stay healthy.