There’s a saying in real estate investing that profits are made when a property is purchased, not when it is sold. That’s one of the reasons why coming up with the right offer price on a rental property is important.
Overpaying for a property can lead to subpar returns, while buying a home at a fair market price – or even below market – may lead to bigger profits over the long run.
Let’s begin by discussing why the right offer price on a rental property for one investor may be completely wrong for another, then look at 3 common ways to determine the price to offer for a rental property.
Key takeaways
- The offer price on a rental property may differ based on an investor’s unique goals, such as fast appreciation versus long-term cash flow.
- Three methods to determine a rental property offer price are the sales comparison approach, income approach, and gross rent multiplier.
- Key metrics to take into account when forecasting the potential return from a rental property include cash flow, cash-on-cash return, net operating income (NOI), and gross yield.
What is the “right” offer price for a rental property?
The price of a rental property that’s right for one investor could be completely wrong for another buyer. That’s because, just as every piece of real estate is unique, the reasons for buying a rental property differ from one investor to the next.
For example, an investor focused on appreciation may be comfortable buying a property with little or no cash flow, or sometimes even negative cash flow. In real estate markets with high rates of appreciation, such as Austin, TX, home prices increased by more than 40% over the past year (Zillow as of December 31, 2021).
That means a middle-price-tier home purchased for $445,000 in December 2020 would be worth nearly $626,000 one year later, for a potential gain of $181,000. If an investor expects home prices in Austin to continue increasing at a similar pace, paying full asking price might make good business sense, even if the property has minimal or no cash flow.
Of course, the potential risk in betting on home prices continuing to rise is that real estate markets historically move in cycles.
During the financial crisis of 2007 to 2009, the median sales price of houses sold decreased by about 20%, according to a chart from the Federal Reserve. Some investors who purchased rental property prior to the crisis, using high amounts of leverage or interest-only loans, ended up selling at a loss or losing homes in foreclosure.
On the other hand, an investor seeking a more balanced blend of risk and reward might determine the right offer price for a rental property based on cash flow or a blend of cash flow and long-term appreciation. Questions to consider when pricing a rental property for cash flow are:
- How much cash is coming in based on the current market rent?
- Is there the realistic potential to increase the rent, based on rental comps of similar nearby properties?
- What is the amount of cash going out to pay for operating expenses, the monthly mortgage payment if the property is financed, and contributions to a capital reserve account?
Based on the answers to these questions, an investor focused on cash flow can quickly calculate the potential cash-on-cash return based on various offer prices.
An investor who puts more emphasis on cash flow may search for a real estate market where the demand for rental property is strong, while home prices are holding steady or even declining. For example, in some of the best neighborhoods in Birmingham, AL, for investment property, more than 50% of the residents rent their homes, while home prices have barely budged or even decreased by double digits over the past year.
3 ways to determine offer price on a rental property
Even though the right price may differ from one investor to the next, there are a few common ways to determine the offer price on a rental property.
Sales comparison
Also known as the market approach or simply running “comps,” the sales comparison approach is used to determine the offer price on a rental property based on recent sales of similar properties in the same area.
The sales comparison approach takes into account home characteristics such as square footage, number of bedrooms and bathrooms, lot size, home elevation, and recent updates. The property being purchased is known as the “subject” property, and the recently sold homes the subject is being compared to are known as “comps.”
If a comp has a better feature than the subject property, such as a brand-new roof, a deduction is made from the comp’s value to make the property the same as the subject property, and vice versa.
The following example illustrates how the sales comparison approach works to determine the offer price on a rental property:
| Subject | Comp #1 | Comp #2 | Comp #3 | |
| Asking/sold price | $150,000 | $160,000 | $150,000 | $170,000 |
| Square feet | 1,200 | 1,300 | 1,250 | 1,400 |
| Bed/baths | 3/2 | 3/2 | 3/3 | 3/3 |
| Garage | No | Yes: -$2,000 | No | Yes: -$2,000 |
| New roof | Yes | Yes: no adj. | No: +$5,000 | Yes: no adj. |
| Adjusted value | $150,000 | $158,000 | $155,000 | $168,000 |
| Price/sq ft | $125/sq ft | $122/sq ft | $124/sq ft | $120/sq ft |
Based on the above comparables, an investor might determine the offer price for the subject home should be between $120 and $124 per square foot, or $144,000 to $148,800, everything else being equal.
There are several advantages to using the sales comparison approach to determine the offer price for a rental property:
- This is the most common approach used by appraisers, so the risk of a property not appraising for financing purposes is reduced.
- Because the income from the rental property is not factored into the valuation, it reduces the risk of an investor overpaying for a rental property that can’t be resold to an owner-occupant in the open market.
- If the rental property does generate a consistent net income, the cash flow is a bonus received from purchasing a home at fair market value.
Income approach
The income approach is typically used to determine the offer price for a commercial property, like an office building or shopping center, larger multifamily properties, or residential rental property in areas where comps are difficult to find.
The income approach focuses on the income a rental property is generating compared to similar properties in the same real estate market, and the annual capitalization rate or percentage return.
A rental property cap rate is calculated by dividing the NOI by the property price. NOI is determined by subtracting normal operating costs, excluding any mortgage payments and capital expenses, from the rental income.
In the example below, the income approach is used to determine an offer price on the 4 rental properties from the previous example:
| Subject | Comp #1 | Comp #2 | Comp #3 | |
| Asking/sold price | $150,000 | $160,000 | $150,000 | $170,000 |
| Square feet | 1,200 | 1,300 | 1,250 | 1,400 |
| Beds/baths | 3/2 | 3/2 | 3/3 | 3/3 |
| Garage | No | Yes: -$2,000 | No | Yes: -$2,000 |
| New roof | Yes | Yes: no adj. | No: +$5,000 | Yes: no adj. |
| Adjusted value | $150,000 | $158,000 | $155,000 | $168,000 |
| Price/sq ft | $125/sq ft | $122/sq ft | $124/sq ft | $120/sq ft |
| Gross rent/yr | $15,000 | $18,000 | $15,500 | $20,000 |
| NOI | $8,500 | $9,000 | $8,500 | $10,000 |
| Cap rate | 5.7% | 5% | 5.5% | 5.9% |
| Value based on cap rate | $180,000 | $154,545 | $169,492 |
Based on the income approach in this example, the cap rate range is between 5% and 5.9%, for an average cap rate of 5.47%. To determine an offer price for the subject property based on the average cap rate, the NOI of $8,500 is divided by 5.47%:
- $8,500 NOI / .0547 = $155,393 offer price for subject property
According to the income approach, the subject property is undervalued by $5,393, everything else being equal. The values of Comp #2 and Comp #3 are about the same using both valuation methods, while the buyer of Comp #1 appears to have bought the property at a very attractive price, at least based on the income approach.
Gross rent multiplier
The gross rent multiplier (GRM) approach values a rental property based on the gross rent generated. GRM is calculated by dividing the property price by the gross annual rental income.
As a rule of thumb, the lower the GRM, the better the potential deal, everything else being equal. That’s because the lower the GRM, the more gross rental income there is relative to the property price.
Let’s take a look at the GRMs of the comparable properties:
| Subject | Comp #1 | Comp #2 | Comp #3 | |
| Asking/sold price | $150,000 | $160,000 | $150,000 | $170,000 |
| Square feet | 1,200 | 1,300 | 1,250 | 1,400 |
| Beds/baths | 3/2 | 3/2 | 3/3 | 3/3 |
| Garage | No | Yes: -$2,000 | No | Yes: -$2,000 |
| New roof | Yes | Yes: no adj. | No: +$5,000 | Yes: no adj. |
| Adjusted value | $150,000 | $158,000 | $155,000 | $168,000 |
| Price/sq ft | $125/sq ft | $122/sq ft | $124/sq ft | $120/sq ft |
| Gross rent/yr | $15,000 | $18,000 | $15,500 | $20,000 |
| NOI | $8,500 | $9,000 | $8,500 | $10,000 |
| Cap rate | 5.7% | 5% | 5.5% | 5.9% |
| Value based on cap rate | $180,000 | $154,545 | $169,492 | |
| GRM | 8.9 | 9.7 | 8.5 |
To determine the offer price of a property based on the GRM, the GRM is multiplied by a property’s gross annual income. Based on the above GRMs, the offer price of the subject rental property should be between $127,500 and $145,500.
That’s a pretty big range in offer prices, which also illustrates one of the drawbacks to using the GRM method to value a rental property. While GRM is quick and easy to use, it does not take into account important information like property operating expenses or NOI.
An easier way to forecast potential return
Warren Buffet once said, “Price is what you pay; value is what you get.”
While the sales comparison, income approach, and GRM valuation methods are all good ways to determine the offer price on a rental property, you can use the free rental property analyzer in this article to forecast the potential return of a property. Simply enter some information to view projected key return on investment (ROI) metrics, including cash flow, cash-on-cash return, net operating income, and cap rate.
