Rental properties are valued by appraisers and lenders using a very specific mathematical formula. The formula is very simple:
1. Figure out the annual income on your rental property.
2. Subtract your annual expenses, not counting your mortgage payment.
3. Divide by the *cap rate used in your market.For our example let’s use a 10% cap rate.
4. The answer to this math formula is the value of your property.
* Cap Rate (Capitalization Rate): This is how commercial property agentproperty and multi-unit apartment buildings are typically valued. The cap rate represents the yield, or the return the investor will receive. The higher the cap rate percentage, the better the deal for the buyer. Cap rates are often used as a negotiating tool between buyers and sellers, and there is often a general “going rate,” or a range of cap rates, that are currently being used in transactions in any given market.
Because of the way the above formula works, you can influence the value of your property adsproperty a great deal by adjusting your income or expenses by just a little bit. This is just like dropping an extra grain of sand onto one side of a perfectly balanced scale. One little bitty grain of sand will cause the scale to
tip! .
1. The annual income on your property is $60,000
2. The annual expenses, not including the mortgage payment, are $20,000
3. The cap rate we’ll use is 10%
Step #1:
$60,000
$20,000
__________ -
$40,000
Step #2:
$40,000
.10
__________ ÷
$400,000
Our property’s value is $400,000!
Now let’s look for our grain of sand that we can drop onto the scale. We need to increase our monthly cash flow by just a little bit. We could enforce our late fee policy, bill our tenants for some of the utilities, increase our rents by a very small amount, charge extra for parking or a storage garage, put a lockbox around the thermostat – there are all kinds of ways. By getting creative with our income, and by shaving off some unnecessary expenses, let’s say we can create an extra $200 per month in cash flow, or $2,400 annually.
Now let’s quickly rework the formula using our new numbers:
Step #1:
$62,400
$20,000
_________ –
$42,400
Step #2:
$42,400
.10
_________ ÷
$424,000
Our property’s value is now $424,000!
You’ve just created $24,000 in equity that you can pull out of the property to use to buy another property. You can buy another cash flowing property without using any of your own cash! You can see here mathematical formula for calculating rental properties valued is very simple.
Using incremental bits of cash flow to grow an exponential passive income stream is one of the best uses of leverage in the world!
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