MAKING MONEY WITH VALUE-ADD PROPERTIES
By: J SCOTT
How does a value add property make money? And how much value can a property owner reasonably expect to add to a property?
While I know this information is already going to be understood by many multifamily operators and investors, it's not uncommon for me to come across new investors -- both active and passive -- who are confused on the topic.
So I wanted to devote a little bit of time and space to this important discussion.
First, let's define "value add."
WHAT IS VALUE ADD
A value add property is one where the resale value of a property is lower than it otherwise could be if the owner were to make some key improvements with the property.
For example, here at Bar Down Investments, we specialize in purchasing value add multifamily properties. These are larger residential properties that we purchase at $X, knowing that with the right improvements, we can add a significant amount of resale value on top of $X.
For example, in this industry, it's not uncommon to purchase a property at somewhere around $15 million that could be resold for between $25 million and $30 million in 5 to 7 years.
While this might seem like an extreme increase in value that requires a lot of luck, in reality, it's about applying relatively simple math to the right properties.
Before we jump into how we can go about increasing the value of properties this greatly, let's talk a little bit about how these types of properties are valued.
VALUING COMMERCIAL PROPERTY
Unlike single family houses, whose values are based on the values of the houses around them, commercial properties are valued based on the amount of income they generate.
In fact, there's a very simple formula to determine the value of a commercial property. You simply take the net income that the property generates and multiply it by a multiplier that is standard for that type of property in that location.
The net income is a very specific number called net operating income, or NOI. This is all the income collected -- rent, late fees, pet fees, laundry collections, parking fees, etc -- minus all of the standard operating expenses incurred by the property -- property taxes, insurance, maintenance costs, utility costs, property Management fees, landscaping, snow removal, etc.
The multiplier is going to be highly specific to the location, the condition of the property, the type of property, etc. For example, a newly built self storage facility he's going to have a different multiplier than a 30-year-old retail strip mall or 15-year-old class B apartment complex.
We often represent this multiplier in the form of a percentage, and we refer to it as a capitalization rate, or cap rate. For example, a 25x multiplier is the same as 4% cap rate.
Note: To go from multiplier to cap rate, justified one by the multiplier (1/25=4%). To go from cap rate to multiplier, just divide one by the cap rate (1/4%=25).
It's more common to use a cap rate than a multiplier to determine value, and cap rates for most commercial properties these days range from about 4% to about 10%, again depending on the type of property, the location, the condition, etc.
To summarize, the value of a commercial property boils down to the following equation:
Value = NOI / Cap Rate
As an example, let's say we were to purchase an apartment complex that had the net operating income of $750,00 and where the location, condition, and other factors indicated a cap rate of 5%.
We can estimate the value of that property to be somewhere around:
Value = NOI / Cap Rate
Value = $750,000 / 5% = $15,000,000
INCREASING THE VALUE
Based on the above value formula, it should be clear that every dollar of new net income created for the property will result in much more than a dollar increase in value.
In fact, in the example above, the property has a cap rate of 5% (which is equivalent to a multiplier of 20x), every $1 of additional net income we can create will result in $20 added to the resale value of the property.
So, how do we create additional net income for the property?
There are essentially two ways:
1. We can increase the income the property is generating; and/or
2. We can decrease the expenses the property is incurring.
To increase the income the property is generating, there are several things we can do. We can spend money to renovate the unit interiors, which would likely increase the rent we can charge. You can do the same thing on the exterior of the property, or by adding new amenities as well. For example, adding a basketball court, a playground, a swimming pool, a gym, etc.
We can also create additional streams of income. For example, charge a monthly fee for premium or covered parking. Add a laundry room and charge for laundry machine usage. Allow pets and charge a pet fee. Maybe allow tenants to rent out a party space on the property.
On the expenses side, we often see owners who are not detail oriented and who don't fight to reduce their expenses by every penny. For example, protesting property taxes to bring them down. Shopping for new insurance carriers who can provide a better cost. Overpaying property Management fees. Not charging back the full amount of utilities to the tenants. Or perhaps paying third party contractors and maintenance people instead of bringing those roles in-house.
Long story short, there are lots of ways that smart, disciplined and creative property owners can increase income and reduce expenses.
PUTTING IT ALL TOGETHER
Let's take that property we discussed above that was valued at $15 million and assume we purchased it. Assume it was a 150 unit apartment complex.
Before purchase, we ran some numbers and determined that at a cost of $20,000 per unit ($3M total), we could achieve the following:
We could improve the exterior of the property, at amenities, and do interior renovations to get the average rental price per unit up by $300 per month. $300 per month across 150 units equals a revenue increase of $540,000 per year.
We could add 50 covered parking spots, charging $35 per month, an additional $20,000 per year in revenue.
By protesting our property taxes, our third party consultant is confident that we could reduce those taxes by $30,000 per year.
Our insurance broker got us a quote for a $15,000 reduction in our annual insurance costs.
By bringing in our own maintenance and leasing staff, we believe we can save $20,000 per year in overhead costs.
Overall, we believe that we could conservatively add $625,000 in net income to the property through these improvements.
That would take our net operating income from $750,000 per year too about $1,375,000 per year.
Assuming the multiplier doesn't change during the time that we are holding the property (we often assume it will change, but to make this simpler, we'll assume it stays the same), we can estimate the resale value of this property as:
Value = NOI / Cap Rate
Value = $1,375,000 / 5% = $27,500,000
We purchased the property for $15 million, we put $3 million into renovations, and we expect to be able to resell the property for $27.5M.
After all of our transaction costs (closing costs, due diligence costs, compliance costs, attorney fees, etc), we could expect to make between $8 million and $9 million on this property.
Note: One big income/expense that I ignored above is natural growth of market rent over time, as well as the increase in expenses due to inflation. Typically, there is a net growth in revenue over time from these things, but I've chosen to ignore that in the above analysis. But, it would contribute to additional growth as well.
And that's how value add property owners use good decision making and simple math to make money for themselves and their investors.