House-flipping, once a viable way for regular people to profit from real estate, has been on a decline in recent years. As that market dwindles, rental property continues to be a good investment and a more attractive one for people who want a stable, long-term investment. Here’s how to determine the value of a rental property.
Flip No Longer Hip?
Once upon a not-very-long time ago, house flipping practically became a mainstream phenomenon, with flipped properties (those bought and sold again within a 12-month period) making up a significant percentage of all homes sold—9% at its peak.
In 2005, flipping even got its own reality TV show: A&E’s “Flip This House” followed pro flippers as they searched for undervalued properties then renovated and sold them. A&E cancelled the show in 2009, after the housing market crash.
The network came back in 2010 with “Flipping Vegas,” which aired its last episode in 2014, coincident with a drop in the percentage of flipped homes to 4%—lower even than 2008’s lowest point.
In 2012 and 2013, A&E brought new “Flipping” shows centered in Boston and San Diego, respectively. But don’t be fooled: according to RealtyTrac’s® 2015 “U.S. Home Flipping Report,” while U.S. flipping is definitely up from its 2008 post-crash low, it has still been on a five-year declining trend.
Go with the (Cash) Flow?
One solution for real estate investors who want to stay in the game is to consider investing in rental property. It practically goes without saying that it’s an entirely different mindset than that of being a house flipper.
The biggest difference is how flippers and investors realize a profit:
- Flippers seek to either purchase property in areas where the housing market is heating up and thus profit from appreciation or to buy fixer-uppers, renovate and sell them for more money.
- Investors seek out properties that will produce sufficient rental cash flow to pay off the mortgage and cover expenses, at which point the rental income becomes nearly 100% profit.
The first question a flipper—or anyone interested in investing in rental property–might ask is “How do you determine if a rental home might produce sufficient cash flow?”
There are several ways to do it. No one method alone should be relied upon as the basis of a decision, but applying several methods to a particular property should give you a good idea if you’re looking at a winner or not.
Sales Comparison Approach
There are more or less complex ways to do a Sales Comparison Approach (SCA). The simpler approach involves analyzing various attributes of a number of similar, recently-sold properties in the same area and comparing those to the proposed investment property. The more complex method applies statistical techniques to a larger number of similar properties over a broader geographical area.
Though properties may be similar, no two are exactly the same, so doing a comparison of a proposed property based on the value per square foot of another or other similar properties in the area doesn’t necessarily confirm what the value of the property is but can help to form an opinion of what it could or should be.
SCAs are generally carried out by certified appraisers or real estate agents.
Capital Asset Pricing Model
The capital asset pricing model (CAPM) is a way to measure the risk of a particular investment and determine what kind of return you can expect on it.
The CAPM is considered a vital calculation to make, but is neither simple to do (for those who didn’t take advanced math classes) nor is it always reliable.
The theory behind the CAPM is that investments that pose greater risks should earn the investor greater returns. An easy way to look at it is to compare the results of a CAPM with investments that have a guaranteed return, such as Treasury bonds. If a rental property suggests it will provide a lower rate of return than a guaranteed-return investment, look for a different property.
To calculate the “cap rate,” you would divide the annual net operating income (primarily rental income, but may also include revenue from parking fees, laundry machines, etc.) by the asking price or value of the property and multiply the result by 100.
Similar to the SCA, you may be able to find out the cap rate of a particular type of house in a specific market by checking with a lender in that market. With such information—as current as possible—you can get a better idea of the value of similar houses.
Cap rate will be affected by the age and condition of the property, which will have a bearing on need for future repairs, and such things as the general economy and crime rate in the particular market, which will have a bearing on tenancy rates.
There is much conflicting opinion in the real estate industry regarding the value of a cap rate calculation. Many agree that its greatest value is in generating comparisons of several properties or to remove obvious losers when you’re analyzing a long list of potential investments.
This approach, which often applies to vacant land, is calculated by combining the land’s value and the depreciated value of any improvements done to it. In the case of vacant land, value is often affected by what appraisers refer to as the “highest and best” use of the land.
For instance, if a developer wants to put up new housing in an area that is not zoned for residential property, the value of the land goes down because the developer will have to spend a significant amount of money to get the area rezoned.
As flipped homes continue to represent a smaller and smaller piece of the overall real estate market, in areas where vacancy is high and stable, it’s always a good time to invest in rental homes, which can produce stable, long-term cash flow.