One of the critical things to understand when it comes to investing in commercial apartments is the formula that is used to determine the value of each complex. Unlike single family houses, where the value is determined based on the structure of a comparable property, the value of an apartment complex is based on the amount of income it generates on a yearly basis. Think of it as a business rather than a building. The more income it generates, the more it is worth. When we purchase an apartment complex, we are looking for specific opportunities to increase the cashflow in different areas. These are called “Value Plays” or “Value Adding Components”.
Value Plays solve problems caused by:
- Poor supervision of management companies
- Mismanagement caused by owner self-management
- Deferred maintenance
- High vacancies
- Below market rents
A single Value Play opportunity can help generate target returns. Here are some examples of Value Plays:
- Increasingrents to current market pricing. Sometimes we purchase properties that are 10% or more under current market pricing. This gives us the opportunity to increase rents and immediately increase the value of the property.
- Improve curb appeal by improving landscaping, adding carports, etc. Tenants will pay more when a property is in better condition or has carports or security gates.
- Implement a water and sewage bill-back system to charge to the tenant for actual usage. In a lot of cases, the apartment owner pays for all of the water. If we bill back the tenant it helps to offset those expenses and increase the cash flow, and tenants get more frugal with their usage, decreasing overall operation expenses.
- Add a coin laundry facility to the complex (may seem minor, but the income adds up quickly).
- Annual rent growth increases by 3-4% per year.
In an emerging market where a lot of new jobs are being generated, the annual market rent increases by 3-4% to support the new demand for housing.
One of the next steps will be to show you the impact that each of these value-add components can have on the value on an apartment complex (remember the more income we generate, the more the complex goes up in value).
In the graph above, you will see the purchase price and the Net Operating Income (NOI). NOI is the gross revenue minus all reasonably necessary operating expenses.
The value of a property is determined by theNOI and the capitalization rate (Cap Rate) for a particular geographicarea.The Cap Rates are provided by local Realtors who keep a pulse on the local market.
Here is an example property that has anNOI of $156,600. The geographic area has a 9.5% Cap Rate (provided by local Realtors). The formula for determining value is NOI/Cap Rate= Value.
Thus, an NOI of $156,600 and a Cap Rate of 9.5 yields a value of $1,648,421. Thus the “strike price” for the proposed purchase is ~1.648 Million dollars
The above graph shows an example ofspecific components/amenities that will be used to add value during a3-5 year hold period. Notice the increase of NOI at the end of 5 years. Increasing the NOI by $71,901 has significantly increased the value of the deal. Here’s the way the new value is calculated:
NOI of $228,501 / 9.5% Cap Rate = $2,405,274 (value)
Keep in mind the mortgage will havealso been paid down during the 5 year hold period, thus adding additional equity that can be shared with investors on resale.
Real estate markets and Cap Rates fluctuate. A 9.5% Cap Rate today, may sell for a higher Cap Rate later if market conditions have changed and financing is less readily available. New properties coming to the marketplace can depress rents and increase vacancies, causing a reduction in NOI. Thus, it is important to invest with seasoned sponsors who specialize in multi-family investments to ensure that all such factors are taken into account during acquisition, operations, and timing the optimum resale period for a specific property.