Price Your Rental Property Based On The Risks You Are Taking

To figure out the price you’re willing to pay for a rental property, you estimate the rent you might get, the annual costs you’ll have to pay, and what it might take to first fix the place up.

When you’ve calculated the net annual revenue, you divide by a capitalization rate to come up with the maximum price you’re willing to pay after deducting the fix-up costs. The cap rate basically is the annual return you expect. (Of course, you hope to pay a lower price and get a higher return.) These days that rate may be around 4 percent, so if you expect a net return of $20,000 per year, you should be willing to pay up to $500,000 for the property.

But if the cap rate is 5 percent, you should only pay $400,000. Clearly, the cap rate makes a big difference. How do you know which cap rate to use?

Traditionally, you find out from a broker what the actual cap rate has been on recent transactions in your area. Finding recent cap rates is an informal process, there aren’t published figures because most buyers don’t want to tell you.

But here’s the point – even if you HAD that information, how confident are you that other buyers knew what they were doing? Just because other people used a cap rate, does that mean you should, too? Every time you’re assured that professional investors know what they’re doing, remember that there was a giant real estate crash in 2008.

We developed a calculation for cap rates for local markets at my company Local Market Monitor by starting at the other end. Forget what rate other investors are using – what rate should YOU be using? A rate that reflects the risks you’re taking.

We start with a market rate for roughly comparable investments and add premiums for risks that can be anticipated. We use the Bank of America Merrill Lynch effective yield on BBB corporate bonds – widely available – as  a market rate and add a premium for investing in real estate, a premium for the chance that local rents will fall, and a premium for the chance that local home prices will fall.

This produces Risk-Adjusted Cap Rates specific to local markets.

The risk premium for investing in real estate – usually a fairly safe investment – depends on current market rates. In early 2017, with the BBB rate just under 4 percent, we add a risk premium of 1/2 percent. Feel free to add more.

The premium for rents only kicks in when the local economy is in lousy shape, either stagnating or actually losing jobs. In such an environment, younger people – renters – move away or move back in with their parents. The demand for rentals shrinks and landlords have to accept rents that are lower than they want. As a rule of thumb, for every percent that local annual job growth is under 1 percent, add a risk premium of 1/2 percent.

The risk premium for the chance that home prices will fall can be large in over-priced markets and is more difficult to estimate by an easy rule of thumb. Our own calculations compare current local home prices with the level they ‘should’ be at in view of local income. It’s an involved process.

You can make a rough estimate by finding out how fast local prices increased in the last few years – you’re looking for a bubble. For every year that prices rose more than 8 percent, add a risk premium of 1/2 percent. If they rose more than 12 percent in a year, add a full percent for that year.

One of the attractions of investing in rentals is that you may be able to sell your property for a much higher price in the future, as home prices rise. And you expect rents to rise as well. But don’t let these possibilities push you into paying a higher price for your investment. These bonuses belong to you, not to the seller. Stick with your cap rate, don’t overpay.

Risk-adjusted cap rates can’t account for every risk, but they can help you adjust the price of your investment to the risks you’re taking.

Right now – in early 2017 – a number of local markets already have rent or home price risk premiums; as the US economy slows during the next few years, and as bubbles reappear, we’ll see even more.

Source: forbes.com