Why do we invest? It’s not a trick question. To make money of course! Hopefully enough money that someday we have what we need to live a comfortable retirement. What I find interesting, though, is the lack of control most investors accept when they make an investment. Maybe due diligence was performed, fundamentals were understood, and projections seemed realistic. But once acquired, most leave it up to Mr. Market to determine the fate of their investments. It’s somewhat of a cross your fingers, hold your breath, “I hope this goes well” mentality.
Although I don’t mind buying and holding stocks and other assets that are at the whim of the market, I was in search of an asset class that had more similarities to how businesses are run and offered more control to help me reach my goal faster. Any good business looks for ways to increase top line sales and decrease expenses, thereby optimizing the bottom line. When you buy an apartment, you are basically buying a business. When I discovered the concept of “forcing appreciation,” I started to see why apartments truly are the greatest asset class.
Primer – How Apartments are Valued
Apartments are different from 1-4 unit homes, as their value and how they compare to similar properties is measured by the income they produce, not market “comps.” Simplistically, “net operating income” or NOI, is calculated by taking the amount of rent collected and subtracting expenses incurred to operate the property. Expenses include maintenance, taxes, insurance, legal, marketing, utilities, etc. Once all these expenses have been subtracted from the effective rental income, NOI has been calculated.
Note that debt service, the cost to finance the property, is not included in the NOI calculation. Since properties are financed in many different ways, with buyers having varying sources and access to capital, it would not be useful in trying to compare properties to one another by including the cost of debt.
Once NOI has been calculated, a multiplier is applied called a “capitalization rate” or “cap rate” for short. Cap rates are tricky to understand. Simply put, they are a measure of market sentiment, demand, and what buyers are willing to pay for an income stream. They vary by market and property class, or quality of the property. You can find cap rate data by speaking with local brokers in your market. They are often published by the large brokerage houses for different markets as well.
As a quick example, let’s say a property has effective potential rent of $250,000. To operate the property, expenses total $150,000, brining the net operating income to $100,000. If the property class and market is trading at a 6.5% cap rate, the property is worth $1,538,461 ($100,000/.065).
Play with the numbers a little bit. You’ll notice that as the cap rate drops, or compresses, the property value increases without changing NOI. As cap rates expand, or go up, property values decline. Cap rate and valuation are inversely related.
Forcing Appreciation
Hopefully you see where this is going at this point. If you want to drive the value of the property up and not wait for Mr. Market to compress cap rates, you need to “force appreciation.” This is one major perk that makes investing in multifamily properties so attractive. Again, like any business you have two ways to improve the bottom line – increase top line sales (rents) or decrease expenses.
We target “value-add” apartments for this reason. These are assets that are a bit older that need some updates to reinvigorate them. By looking for properties that are in areas where competitive units are already commanding a rent premium by offering nicer amenities, there is an established blueprint achieving higher rents.
The other opportunity to add value is through operational efficiency, usually through expense reduction. Perhaps the landlord has been paying for water for tenants because units are not separately metered. By implementing smart technology that measures water usage at the unit, the landlord can bill water back to the tenants, reducing expenses and encouraging less water usage.
Forcing Appreciation in Action
We are in the process of repositioning a 40-unit apartment at the time of this writing. Classic, or pre-renovation, one-bedroom units are renting for $475. The cap rate in this market for similar properties is 7.5%.
Our value-add plan is to completely update the property exterior, common areas, and interior units. The overall community upgrade will make it a much more attractive place to live. The interior upgrades will consist of new cabinets, counters, appliances, flooring, and bathrooms. Cost to make these upgrades is ~$7,500/unit.
There a two other apartment complexes adjacent to ours. One is close in age and looks similar to our property on the exterior. The units were upgraded 5 years ago, with one-bedrooms renting for $550. The other property has one bedrooms renting for $675. This community has amenities we don’t have at ours, like a pool, playground, gym, and clubhouse.
With our upgraded units the pre-renovation target was $575/unit, which we are now getting. The question is whether the additional $100/unit we can command after our rehab is worth the $7,500 we are putting in to achieve it! Let’s see.
$100/unit x 12 month = $1,200/yr in additional revenue
$1,200/yr / .075 (7.5% cap rate) = $16,000 in added value
$16,000 – $7,500 cost = $8,500 net gain
So for every unit we renovate, we more than double our money we put in. The answer is yes, it’s worth it!
Wrap-up
This is an important concept to understand, whether you are looking to actively get into apartment investing, or if you would rather invest with a value-add sponsor passively, while you collect the checks. The potential of executing upgrades to grow an income stream is exciting and something that can be forced. Additionally, when the property is sold, asset appreciation will be realized.
Forcing appreciation also offers a defensive buffer for the investor. If cap rates expand, or rise, all things being equal, the property value would be less than what was paid for it. However, if the property has been improved, and rents have risen as a result, the additional income will help offset any cap rate expansion, and protect investor principal. This makes the investment less prone to the whims of the market.
Mr. Market can be very kind, but what he giveth he can also taketh away. Some investments don’t offer the control or ability to implement a business plan to make them more valuable. With apartment investing, as an active or passive investor, you don’t have to wait for Mr. Market to determine the outcome of your investment. You force appreciation. This, along with many other benefits, make investing in apartments one of the best decisions you can make to control your future.
Paul Shannon is a full-time active real estate investor, as well as a limited partner in a number of syndications. Prior to leaving the corporate world, Paul worked for a medical device company, selling capital equipment to surgeons in the operating room. After completing a few rehabs employing the “BRRRR method”, he saw scalability and more control over how he spent his time, and left to pursue real estate in 2019. Since then, Paul has completed over a dozen rehabs on both single-family and multifamily properties. He currently owns over 50 units in Indianapolis and Evansville, IN and is a limited partner in larger apartments and industrial properties across the US. You can connect with him at www.redhawkinvesting.com
Nothing on this website should be considered financial advice. Investing involves risks which you assume. It is your duty to do your own due diligence. Read all documents and agreements before signing or investing in anything. It is your duty to consult with your own legal, financial and tax advisors regarding any investment.
