Making Money in a Real Estate Deal
By Andrew Gaines
There are three main ways to make money in a real estate deal: increase revenue, decrease expenses and create value through capital investment. In a minute, I will give you three real-world examples of how this works in an apartment deal. First, we need to briefly review how the value of an apartment building is determined. It’s important for understanding the magnitude of value created in any scenario.
The value of an apartment building is a function of the net operating income (NOI) and the capitalization rate (cap rate) for the market where it is located. Dividing the NOI by the cap rate provides a good estimate of the value of the property. Therefore, modifying either one or both of them will impact the valuation. An investor has no control over the capitalization rate since it is determined by the market. Net operating income, however, can be directly influenced by an apartment owner. By raising the NOI the value of the apartment is increased. This can be accomplished in the three ways listed above. In what follows, I will give you three concrete examples of how this works and show how changes in NOI lead to outsized value changes in light of the prevailing cap rate.
Example 1 – Increase Revenue
Suppose we own a 100-unit apartment valued at $10M in a market with a cap rate of 6%. The NOI for that building should be $600,000 annually. This building has 100 parking spaces, thirty of which are covered. Historically, management has not charged a fee for utilizing the covered spaces. If a policy change is implemented requiring reservation of a covered space for $25 per month this will result in a straightforward increase in the NOI since there is no new additional cost associated with using those parking spaces differently. If all thirty spaces are reserved, monthly income will increase by $750 and NOI will be up $9,000 over the next year. The impact of this simple change on property valuation is greater than just the $9,000 because it is connected to the cap rate. In order to see the impact on value, we divide the NOI increase by 6%. That reveals a $150,000 increase in property value. Every dollar added to the NOI resulted in an addition of $16 to the value of the building.
Example 2 – Reduce Operating Expenses
We have just acquired a 50-unit building from a long-term individual owner. It is valued at $5M in a 6% cap rate market. That owner had been self-managing the property using a tenant as an onsite manager in exchange for rental concessions. In addition, there was no dedicated maintenance staff for the property. All maintenance personnel was independent contractors. For this reason, maintenance expenses appear to be about 10% higher than what could be expected for the property with a third-party property manager in place who utilizes in-house maintenance staff. Repairs and maintenance currently cost $900 per unit or $45,000 annually. If we reduce this number by 10%, that will result in a savings of $4,500 per year. All else being equal, that translates into an increase in the NOI by the same amount. Applying the cap rate to this yields an increase in property value of $75,000.
Example 3 – Make Strategic Capital Improvements
The 50-unit building we just acquired in the example above also has a common laundry that generates $7,000 in revenue for the property each year. However, there is a strong preference for in-unit laundry. Installation of in-unit hookups could be accomplished for $300 per unit but would allow for rents to be increased by $35 per month for those units. If it is possible to complete the installation of hookups in 25 units over the course of the next year when the units are turned over for new tenants at the increased rental rate, then our NOI will increase by $10,500. Since the common laundry is still in operation it still generates some revenue. If it takes another year to install laundry hookups in the remaining 25 units, we will not see the full benefit of the property value change until then. However, when all units are upgraded and rented at the higher rate the NOI will have increased by $21,000. There will be some further reduction of income from the common laundry that offsets this increase. Nevertheless, for the purpose of illustration, the value change would be $350,000 at a cap rate of 6% for an NOI increase of $21,000. If we offset the loss of common laundry income completely such that our NOI only increases by $14,000 then the change in property value would still be $233,000.
It should now be obvious how small changes in net operating income result in significant changes to property value. This is the essence of how money is made in an apartment real estate deal. Now imagine if we are able to stack these various strategies one on top of the other within a single investment business plan. It is not difficult to see how an investor could add $500,000 or more of value to a property through a combination of revenue enhancement, expense reduction, and capital improvements. These are exactly the strategies, among others, that smart investors employ when acquiring investment real estate.