There are 4 ways to make money investing in real estate:
- Rental Income
- Debt Paydown
- Tax Savings
Appreciation is by far the most powerful.
However, when you buy a single-family home, you don’t control appreciation.
The value of a single-family home is based on the “comps”.
Or what others are willing to pay for it.
You have very little control over the most influential variable, which isn’t ideal.
Commercial real estate is different.
You can acquire a commercial property and “force” appreciation through “value-add” enhancements that drive net operating income, or “NOI”.
In today's newsletter, we’ll break this down using a deal I invested in last year.
Let’s do this.
This 22-unit garden-style apartment complex was built in 1983.
As you can see, it’s a bit outdated:
Check out the interiors:
Value is based on the relationship between two variables:
NOI and Cap Rate
Rental income less operational expenses.
Operational expenses include property taxes, repairs, maintenance, utilities, insurance, etc.
Importantly, NOI excludes your principal and interest payments.
We have 22 units generating $670 per unit per month of NOI.
That means we are buying $176K of “in-place” Annual NOI.
2. Cap Rate
The capitalization rate is a property’s Annual NOI divided by its Purchase Price.
If you’re familiar with the concept of a “multiple”, it’s the inverse of that.
The lower the cap rate, the higher the purchase price.
We are buying this property for $4.1 million.
That means our “in-place” cap rate is 4.3%.
—> $176K / $4.1M = 4.3%
If you’re thinking, “whoa that seems expensive,” you’re right.
But for context:
- This was purchased in early 2022 when interest rates were still quite low.
- Entry cap rates are less important for value-add deals. You’ll see why.
We don’t have control over cap rates. The market determines those.
So to increase the value of the property and “force” appreciation, we need to increase NOI.
The best way to do this is to generate more income.
The in-place rents are $1,100 per month, which is ~27% below the market average.
By completing smart renovations, we can increase rents above the market average.
Check out a renovated unit:
Post-renovation, we’ll charge $1,750 per month (+60% increase).
We can supplement our higher rental income in 3 ways:
- Utility Reimbursement: require tenants to pay for all utilities
- Parking Income: charge for a reserved carport space
- Pet Income: charge a market-standard pet fee
Altogether, we will increase our income by more than 70%.
Here’s where things get interesting.
The Annual NOI grew from $176K to $300K (+70%)
That means we generated an additional $124K of NOI.
At a 5% cap rate (slightly higher than what we purchased it for) we created $2.5M of value.
—> $124K / 5% cap rate = $2.5M
We can “unlock” this value by either selling the property or refinancing.
The latter is a common approach to access the value you created without paying tax.
It’s a key piece of the Buy, Borrow, Die Strategy.
Alternatively, we can sell the property, pay capital gains tax (or 1031 exchange), and repeat on another property.
This is the exact strategy real estate private equity firms use to consistently generate strong returns (20%+) in any economic environment.
The past decade has been exceptionally kind to multifamily investors.
Cheap debt, surging rents and huge government stimulus have buoyed prices.
But things are changing.
Interest rates have doubled, rent growth is tapering and large piles of debt are coming due.
What does this mean?
There will be winners and losers.
Winners will take advantage of desperate sellers and general fear in the market.
Losers will ignore the signals and take on too much debt that relies on unrealistic rent growth assumptions.
It's more important now than ever before to proceed with caution.
The value-add playbook is a powerful wealth-building strategy.
For every $1 of NOI you create, you increase the property’s value by $20 (assuming a 5% cap rate).
If you found this interesting, but don’t have the time, knowledge, or capital to pull this off on your own, I would encourage you to invest alongside experienced syndicators as a Limited Partner.
As always, thank you for reading.
I've received a number of inquiries asking if I offer consulting services.
While it's not something I typically do, I've decided to open up a limited number of spots to give you the option.
Each session will consist of 45 minutes of live video discussion and 15 minutes of follow-up.
For now, I've opened 15 slots at a rate of $100 per session.
If you have any questions, simply reply to this email.
Have a great weekend,