The Great A-HA! Lightbulb Moment

Why multifamily?

I’ve asked that question since first learning about commercial buildings in college. The challenge was, well, it was a challenge to understand!

Single family homes

Single family homes (“SFH”) are fairly straightforward. Value is based on what other homes, or comparable sales, comps for short, are selling for nearby. You can project post-rehab value based on comps as well. Simple.

The advantage of SFH investing is its simplicity.

The challenge of SFH investing is its simplicity.

Let me explain.

There is a limit to how much you can increase the value of a SFH. If the nicest home on the block sold for $400,000, the likelihood of you fetching greater than $400,000 for the flip post-rehab is limited.

Even if you found a buyer willing to offer greater than $400,000, would the bank’s appraiser be able to justify that higher value when the best comp is only $400k?

Now, in a hot market, like 2021, values are trending upwards. So it’s quite plausible that both the buyers in the market, and the appraiser for the lender could justify paying above what the highest similar comp sold for. Yet, there’s still a limit.

How are Apartments Valued?

Commercial real estate, multifamily (5 or more residential units) being an example of that, is a whole different animal.

The value of a commercial property is predicated in large part on the amount of net operating income (“NOI) it generates. NOI equals the revenue less the operating expenses of the building. NOI does not factor in debt service (mortgage payments).

To increase the value of a multifamily property, you seek ways to increase its NOI. This can be achieved both through the increase of revenue the building generates and/or the decrease in expenses to operate the building.

What about comps?

In the commercial world, especially for an existing, stabilized (85% or greater of the units are occupied), the majority of weighting is given to the income method of valuation and less on the sales comparison method.

It is still prudent to evaluate comps of nearby commercial buildings, but generally for a different reason than looking at the price alone.

As I mentioned earlier, the value of a commercial property is dependent on the income it generates, however, the income alone doesn’t indicate the price you’ll pay for the property.

Let’s look now at the capitalization rate, or cap rate for short. The net income of a building divided by the cap rate determines its value.

So, what is cap rate?

Great question! This very concept is what did not click in college, therefore rendering the concept of commercial investing too difficult to grasp.

It did not click out of college when I was deciding between becoming a commercial real estate appraiser, or a residential one.

It did not click when presented the opportunity to pursue a commercial brokerage license, vs a residential sales license.

It did not click when I first started investing, as the simplicity of SFH investing was enticing.

Then, one day, A-HA! The lightbulb moment. It hit me like a ton of bricks.

Cap rate. In all it’s subjective glory, finally made sense!

A massive spark of energy jolted me for what lay ahead.

To simplify cap rate, I define it as the rate of return that an all cash investor is seeking for a building in any given market. That expectation of return will vary depending on many factors: the location of the building, the condition of the building, the mix of residential vs commercial space (if a mixed-use building) etc.

Here’s an example

Let’s assume a hypothetical stabilized 40-unit building in a “B-class” location. The building generates $250,000 of annual NOI. The sales price was $5,000,000. Taking $250,000 divided by $5,000,000 yields a cap rate of 5.0%. So in this instance, the investor was willing to accept the equivalent of a 5.00% rate of return for purchasing this stream of net income.

Now let’s pick that very same building up, and place it in a more desirable “A-class” location. The building is exactly the same. The same occupancy. The same deferred maintenance. The same capital improvements are needed. The only difference is where that building is located.

This same investor recognizes the increased desirability of this location and in many cases would be willing to accept a lower rate of return for the same stream of income.

Let’s assume this same building now sold for $6,000,000. Take the $250,000 stream of net income, divided by the purchase price, and your cap rate is 4.17%. This investor is willing to accept a more modest 4.17% rate of return for this same stream of income. Why? Because the location is more desirable, which presumably translates to a more stable investment.

Let’s now assume this same building is picked up and dropped in a less desirable “C-class” location. This hypothetical C-class location may have higher crime rates, limited access to shopping, greater deferred maintenance on neighboring buildings etc.

Now let’s assume the building sells for $4,000,000 for the same $250,000 stream of net income. The cap rate here is 6.25%. The same investor now demands a higher 6.25% rate of return for the exact same stream of income.

Armed with that market cap rate, you can determine an appropriate value for the building of interest.

Interesting, so how do we use that to our advantage?

Let’s revisit the A-HA moment.

If the 2 main factors of multifamily valuation are NOI and cap rate, which of the two can I influence?

Cap rate is the general expectation of risk-adjusted return in the marketplace as a whole. There is little an investor can do to directly influence the going market cap rate.

NOI, on the other hand, is fair game.

NOI, as a reminder, is the overall revenue (ie: rent, pet fees, late fees, laundry income etc) less the operating expenses (ie: taxes, management fees, maintenance etc).

The ability exists to directly influence the NOI, and “force appreciation,” or an increase in value, by pulling on either of these levers. Increasing revenue increases NOI. Decreasing expenses also increases NOI. Doing both simultaneously is even better.

Dividing that now higher NOI into the market cap rate yields the new valuation of the building.

Revisiting that sample 40-unit building above, in it’s hypothetical B-class location, with an initial NOI of $250,000 and market cap rate of 5.00%, yields an initial value of $5,000,000, which is the price we paid.

Fast forward 2 years, and let’s assume we were able to increase revenue by $40,000/year and decrease expenses by $10,000/year, our NOI has now increased from $250,000 to $300,000.

So does that mean the building is worth $50,000 more? NO!

Remember, we as commercial investors are purchasing a stream of income. The price we pay for that stream of income is dependent, in part, by the market cap rate, or risk-adjusted expectation of return, for that building in it’s given location.

Exponential growth in value!

By increasing the NOI of the building by $50,000, and assuming the same market cap rate of 5.00%, the value of the building has been increased by $1,000,000!

Huh? Take the $50,000 NOI increase and divide into the 5.00% cap rate, which yields a $1,000,000 “forced appreciation” of that building.

The next investor would be willing to pay $1,000,000 more for the very same building as the stream of net income it generates is $50,000 higher each year.

This is the power of commercial investing. This was the lightbulb moment for me. Did it click for you too?

To boil it down to the most simplistic level

For every $1 we are able to increase NOI, all things being equal, the value of the building would increase by $20.

This “value-add” approach to investing is a powerful wealth building force.

There are, however, variables in play that could impact the ultimate outcome. What if cap rates increase? Yes, this does and will happen at times. When we analyze a deal, we always assume the cap rate will be higher upon sale of the building. This is known as the “exit cap rate,” “reversion cap rate” or “terminal cap rate,” all are synonymous with one another.

A higher cap rate means investors now expect a greater rate of return for the same stream of income. If cap rates in the scenario above had risen from 5.00% to 6.00%, that same $50,000 additional stream of net income would only be worth an additional $833,333.33.

Still, not too bad, eh?

Now keep in mind that this is a simplistic example. There are plenty of other variables in play that were not touched on here.

Did rehab dollars have to be spent to achieve that increase NOI?

What if rent growth decreased or expense growth increased?

Is there a prepayment penalty upon year 2 sale if a loan existed?

What about closing costs to sell the building?

All of these factors and more are accounted for when underwriting, or analyzing, any deal we consider. We take a conservative approach to underwriting, which is why it takes on average 100 deals analyzed to find 1 deal worth pursuing.

The main point of emphasis is the exponential growth potential in commercial real estate that can’t be achieved in one-off SFH investing.

How to thrive in an up or down market?

Forcing appreciation through influencing the NOI of a building helps weather headwinds in softening markets. On the flip side, it adds rocket fuel to rates of return in strengthening markets where cap rates are compressing, or going down.

For instance, that same $50,000 NOI bump in a now 4.00% cap rate environment would yield a $1,250,000 increase in value.

So, cap rate, let me express my gratitude to you. Your purpose evaded me far too long, but now we’re hand-in-hand, and the future is bright.

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