This blog post illustrates the power of commercial real estate – specifically, for cash-flow producing assets (e.g., multifamily/apartments, self-storage). As a real estate investor, it is important to know if a property will appreciate. We invest in assets that produce cash flow on day one, but also calculate if the property will appreciate during the investment hold period. You ask: “What do you mean that you “calculate” if the property will appreciate? Doesn’t the market dictate if the property will increase in value over time…like my house?” The simple answer is that this is much different and much better as an investor than residential real estate….I am talking about the Commercial Value Formula.
Residential real estate is valued based on “comps” – comparable properties that have sold within the past 90 days in the area of a subject property. Let’s say you purchased a home for $500,000 and then invested an additional $250,000 to put high-end finishes throughout the home with a luxury kitchen and bathrooms. However, all “comps” based on sales in the past 90 days in your area show home values of $600,000. Your home value is pegged at $600,000…maybe a little more…maybe a little less. But even though you invested $750,000, you likely will not get your invested money back. You most certainly will not get a return on that investment.
The Commercial Value Formula is a powerful formula that cannot be achieved with residential real estate. Commercial real estate is valued as the net operating income (NOI) divided by the capitalization rate (also known as the “cap rate”).
Commercial Real Estate Value = NOI / Cap Rate
The NOI includes all revenue generated by the property less the operating expenses. Operating expenses do not include the debt service payments. The cap rate is the potential rate of return on a property (in a particular geographic market at a particular time) if it was sold for cash. For a given NOI, the lower the cap rate is, the higher the value is. On the other hand, the higher the cap rate is for a given NOI, the lower the value is. Cap rates increase as you go from Class A properties to Class B, C and D properties.
When you look at this simple formula, you can see that to increase the property value, you can increase the NOI by either increasing the revenue or decreasing the operating expenses. In many cases, investors will find they may be able to do both. This boosts the property value significantly. This phenomenon is called Forced Appreciation.
Increasing Income
As an investor, your first look at increasing income is simply to raise rents. Rents can only be raised if the current rents are below the market rent. When evaluating what the market rent is, it is important to consider the same quality, size and amenities offered in the unit in that submarket where the asset is located. An investor can see how effective in raising rents is to increasing the value by using the Commercial Value Formula.
Let’s say we increase the rents by only $10 per month per unit for a 75-unit property. This would result in an increase in NOI of ($10/month/unit x 12 months/year x 75 units) or $9,000. Let’s also say the property is in an area with a Cap Rate of 6%. The increase in value using the commercial value formula is $9,000/0.06 or $150,000. How modest is a $10 increase in rent?!? And look what it did to the value of the property?!?
Another way to increase income is to bill tenants for water, gas and/or electricity expenses. This is known as RUBS (ratio utility billing system), a method of calculating a tenant’s utility bill based on occupancy, apartment square footage, number of beds, or some combination thereof. Other ways to increase income are to consider specific fees for benefits offered to the tenants such as pet fees, parking fees, or renting out space in common areas for meetings or other types of activities.
Decreasing Expenses
As an investor, your first look at decreasing expenses is to take a close look at the property management company. Most older properties that are classified as Class B or C property types have inefficiencies because of how they are being managed. Remember that property value can be increased significantly by simply reducing expenses (without any increase to rents)!
Expenses can be decreased by renegotiating contracts such as cable/internet, refuse removal, marketing efforts, and landscaping or by reducing the use of utilities in the building(s) to reduce costs. Investors can also evaluate the current property management company and their business practices with their staff. Is the money efficiently used when a unit is turned over from one tenant to another (known as “make ready”)? “Make ready” spending can be mismanaged. You can see what only a $10 decrease in expenses (which is a $10 increase in NOI) does to the commercial value.
Strategy of Forced Appreciation
The key in forced appreciation is to invest in properties where these strategies can be used to boost revenue and cut expenses to increase property value significantly without additional out-of-pocket investment money. This dramatically reduces risk to the commercial real estate investor because value increases, and it is within the control of the investor…unlike residential real estate markets that can be beyond the control of the investor.
