…Part 1 shared details of one of our favorite investment strategies. In this segment we’re going to calculate the benefits of these strategies which allow us to grow our asset value without solely relying on market appreciation.
In Part 1 we outlined several strategies to increase the net operating income that an asset produces. It takes time, effort, persistence and creativity and when done correctly the end result is highly favorable.
Now let’s review how to calculate the benefit of implementing NOI growth strategies:
Here is a straight forward and common example: Let’s assume we are looking at a 300-unit apartment community and the units on average are renting for $775 per month.
Let’s assume the apartment interiors are a bit outdated and let’s assume that after investing $4,000 in upgrades per unit, a newly remodeled unit is able to achieve $850 per month.
That’s only an increase of 9.7% or $75 per month, doesn’t sound like much does it?
Is it worth it?
Let’s do the math…
Spending $4,000 gets us $900 more per year, so it would take about 4.5 years to recoup our investment which is attractive but doesn’t paint the full picture.
To look at the true value of the upgrades we must extrapolate the increase in NOI to the increase in asset value.
Today, many apartment communities in attractive locations are being sold between 4-6 caps. The capitalization rate or “cap rate” is a simple formula that calculates the value of an income producing property:
Capitalization Rate = Net Operating Income / Purchase Price
Here is a cap rate example: An apartment community purchased for $8,300,000 which returns a net operating income of $500,000 has a 6.02% capitalization rate. If the purchase price was $9,000,000 the capitalization rate would drop to 5.55%.
Now back to our example: We spent $4,000 to upgrade an apartment and now it earns $900 more annually. At a 6% cap rate this $900 would increase the property value by $15,000! At a 5% cap rate the $900 would result in the property value increasing by $18,000.
Let’s take it 1 more step…
Let’s assume that ½ of the units at our 300-unit apartment community are outdated and can achieve on average $75 more per month after a $4,000 renovation.
Let’s assume we have an amazing team in place that can renovate 5 units every month, to renovate 150 units would take 30 months and it would cost $600,000.
The result after 2.5 years would be $900/yr/unit x 150 units = $135,000 increase in income.
At a 6% cap rate the annual $135,000 increase income would result in an increase in property value of $2,250,000!
Now you can see why this is one of our favorite investment strategies.
We can increase the value of the property without relying strictly on market appreciation, without much speculation and we can control the process.
A few things to keep in mind:
- Know your market, study the comparable rental rates, what are other similar units in the area achieving?
- Don’t overspend, calculate the return on cost, a good goal is to be at about 20%. A $4,000 renovation got us $900 annually = 22.5% return on cost
- Avoid over renovating, don’t install marble flooring in a class B apartment!
- Offer existing tenants a light rehab to stay at an increased rate, new blinds, light fixtures and painting an accent wall can go a long way