Single Family homes offer good returns and excellent potential for appreciation. As demand for housing raises so does the price of your investment property. So long as your home is in a desirable area for an end user you should see great appreciation as the market recovers from this most recent downturn. Appreciation however, is completely dependent on the subjective desires and financial ability of the “perfect buyer” and directly related to uncontrollable market forces.
Multi-Family apartment property however, while partially driven by subjective value assessments; is more heavily driven by objective facts that can be counted and quantified. Since this kind of property is almost never purchased by an end user to live in personally, the value of such a property is directly related to the amount of income the property produces after all expenses and a risk premium.
Here’s how the math works:
Apartment building “A” consists of 10 separate rental units. Each unit rents for $500 a month, giving the total amount of rents the building could earn per year of $60,000 (also called Gross Potential Rent - GPR).
Let’s say the cost of running the building however (including maintenance, insurance, management, property tax, leasing fees, vacancy etc…) is about $25,000 a year
$60,000
-$25,000
$35,000
$35,000 represents the Net Operating Income (NOI) of the property, or the cash flow the investor may receive per year by purchasing the property.
To calculate what this means to the value of the property, you simply need to divide the Net Operating Income ($35,000) by the rate of return the investor looking to buy it is going to want in order to justify the risk they perceive in owning this property over other investments. This rate of return is also called a Capitalization or Cap Rate.
For this example let’s assume we would want to make at least an 8% return on this investment. Take $35,000 and divide by 8%.
This gives us the value this particular investor would be willing to pay for the apartment complex: $437,500
This of course is a simplified version of the formula, but it illustrates the concept of Multi-Family valuation, and helps bring us to my first advantage an apartment building can have when it comes to appreciation.
Inflation Multiplier
Over the long term, Single family homes during normal times appreciate at or about the rate as inflation (excluding peaks and troughs). So a $100,000 home after a year with about 3% inflation would be worth ~$103,000.
Rents also have a direct connection to inflation. So our property “A” with $500/mo rent the first year could raise rents ~3% a year, so after your first year rents might be able to be raised to $515/mo. Plug this new rent into our value formula….and that 3% rise in rents translates to the new value of property “A” to be $460,000, a $22,500 increase in value, or 5.1%; Multiplying the natural dollar increase in market value from year to year.
This multiple increase in value based on rents translates to several creative ways to significantly increase the value of a property; particularly, property repositioning and cost saving.
Value Add
Absentee owners, bad management, loss of owner interest or complacency, over-leveraging, personal or business need for cash….these are just a few of the reasons an apartment can be ignored, left to degrade, demand less rent or have a higher vacancy than it would otherwise demand.
Let’s build on our previous example, “Property A”, that we just purchased at an 8% capitalization rate for $437,500.
Units are renting for $500/mo, but just down the street similar sized units rent for $700/mo. We identify that the exterior of the apartment looks bad, needs to be painted, there is trash in the parking lot, and it generally just doesn’t have any curb appeal. The insides of the unit’s have also not been updated in 25 years and could use new counters, cabinet faces and some electrical updates. You decide that investing into the property to fix these issues, and re-position the property to attract higher rents is the best way to improve value.
Over the first year you clean up and update the property for a cost of $100,000 to bring it up to par with the apartment down the street and are able to successfully raise rents up to market at $700/mo. Also during your renovations you were able to decrease your maintenance expenses and found less expensive insurance, decreasing your total cost from $25,000 a year to $20,000.
Now that the property looks great and is fully rented, you do the math and realize you are now seeing about a 12% return on your investment!
$84,000 GPR
-20,000
$64,000 NOI
But even better, you realize that the investor market is still looking to purchase apartment buildings at an 8% cap rate. You apply our valuation formula and realize your $537,500 total investment is now worth $800,000!!!
Again, this is a simplified example but the principal is illustrated well and shows the powerful concepts behind making a great return on Value-Add Multifamily Property. It’s not all easy money of course and re-positioning a property requires skill and expertise, so be sure to read my follow up “Disadvantages of Apartment Investing, and How to Overcome Them”.
