Multifamily is a popular investment vehicle for savvy real estate entrepreneurs who want to invest at scale. It provides more operational efficiency and risk mitigation than single family. However, the most enticing benefit of apartment complexes and commercial real estate in general is arguably forced appreciation. The rest of this article will explain how investors use this concept to create millions in value in a few years.
Before we get started, please note: You should not take this article as investing advice. Please seek guidance from a financial advisor before making any investment in real estate.
How is single family real estate valued?
To understand the power of forced appreciation in multifamily, let’s first look at residential real estate. If you’ve bought a home before then you might know that single family properties are valued based on comparable properties (comps). That means that appraisers, agents, and other real estate professionals will look for other recently sold properties in the area that are similar in size, bed and bath count, age, and several other factors.
They will then use the sale prices of these homes to value your home. You can renovate a house to force appreciation but only to the value of the comps in the area. You also are often at the mercy of an appraiser to pick appropriate comps, which is not always an objective process.
How are multifamily properties valued?
Apartments, like all commercial real estate, is considered a business and is valued based on the income. Let’s dissect what that means.
All rental properties have a Net Operating Income (NOI) which is the sum of Revenue (all money coming into the property) minus the Expenses (all money being spent by the property). The equation looks like this:
NOI = Revenue – Expenses
It is important to note that debt service (the mortgage payment) is NOT included in NOI because debt terms will vary from buyer to buyer and could skew the asset’s value.
The next important value to know is the Cap Rate, which is the ratio of the property’s income to its value. Cap rates are typically a characteristic of the market in which you’re investing. A lower cap market is seen as more desirable by investors and the properties will have higher pricing relative to their income. Higher cap rate markets are seen as less desirable and riskier and will be cheaper relative to their income.
Cap Rate = NOI/Value
Taking this equation and solving for the Value, we get the following:
Value = NOI/Cap Rate
I stated previously that cap rate is a characteristic of the market. It can’t be controlled by any investor. Cap rate compression is when a market sees a decrease in cap rate overtime, indicating an increase in desirability and increase in price relative to income. Cap rate expansion is the exact opposite. In short, compression = market improving, expansion = market declining. Note that cap rates fluctuate over time, and short-term cap rate expansion is a part of a healthy long-term market growth.
Savvy investors do the proper analysis to find markets that are growing and, therefore, should see cap rate compression. Still, most operators will assume cap rate expansion in their market to be conservative.
Let’s get back to the equation. Let’s assume the cap rate stays consistent to normalize market conditions. The most direct and controllable way to increase property value is to increase the NOI. This means increasing revenue and/or decreasing expenses.
The Value-Add Multifamily Strategy
By finding underperforming properties, operators can find opportunities to take over a property and improve operations to improve income. These properties typically lack amenities or upgrades to get rents in line with the rest of the market. Or they have operational inefficiencies that keep their expenses or vacancy higher than necessary.
A competent syndicator can implement a business plan to address these insufficient amenities and inefficient operations to increase NOI and increase value.
Here’s an example :
Let’s say you find a 100-unit property that has rents at $1000 per unit per month. With a vacancy rate of 5%, the annual revenue would be:
100 units x $1000 rent x 12 months x 95% occupancy = $1,140,000
This same property has $6,500 in expenses per unit per year. The annual operating expense total would be:
100 units x $6500 in expenses = $650,000
The NOI would be:
$1,140,000 – $650,000 = $490,000
In a 5% cap rate market, the value would be:
$490,000/0.05 = $9,800,000
In acquiring this property, you have a 5-year business plan to increase the rents by $150 per unit per month and reduce expenses by $1000 per unit per year.
With the same vacancy rate of 5%, the annual revenue would be:
100 units x $1150 rent x 12 months x 95% occupancy = $1,311,000
The annual operating expense total would be:
100 units x $5500 in expenses = $550,000
The NOI would be:
$1,311,000 – $550,000 = $761,000
To be conservative, we’ll assume a 5.5% cap rate market at exit, indicating the market declines in the 5 years you own it. The new property value would be:
$761,000/0.055 = $13,836,363
Subtracting the acquisition value from the exit value we get:
$13,836,363 – $9,800,000 = $4,036,363
With successful execution, you’re able to create over $4M in value in 5 years. Even more impressive is that you accomplish this in a declining market! This is a result of just $150 rent increases and $1000 expense reduction per unit, both very reasonable improvements in this industry. That’s the power of scale!
If it seems simple, that’s because it is. The strategy is simple; however, the execution is not easy. Operating multifamily real estate should be taken seriously and should always involve experienced partners! If you’re interested in being notified of our future investment opportunities, sign up for our mailing list.
