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There are two types of investors when it comes to commercial real estate investing: speculators and smart investors. The former take bets on the asset’s appreciation over time based on the market, aka organic appreciation, and rely purely on an increase in value over time based on the market conditions. Smart investors, however, know how to add value to an asset and, therefore, force appreciation.
How does one force an appreciation? To answer that, we need to understand some concepts that actually determine the value of a commercial real estate asset.
The first is the concept of net operating income, known as NOI. Net operating income is equal to “all revenue from the property, minus all reasonably necessary operating expenses.” NOI is a before-tax figure that excludes principal and interest payments on loans, capital expenditures, depreciation and amortization.
The second thing that determines the value of an investment property is the capitalization (“cap”) rate. Cap rate is defined as the rate of return on the real estate investment property based on the income that property is expected to generate.
Here is the all-important equation: The purchase price or the property value is determined by the net operating income divided by the capitalization rate. Price or property value = NOI / cap rate.
Hold on to that for just a bit.
Let’s say you have done your due diligence and found an ideal investment property. It’s a 100-unit apartment complex, fully occupied but with opportunity to add value, i.e., it has outdated interiors, some deferred maintenance and below-market rents. The current owner decided to move on and is not willing to put in the expenses to improve the property. Great for you.
You pay $8 million to purchase the property. The current rents are at $800 per unit. And for simplicity, let’s assume there is no other income, in which case the total income from the property is 100 x 800 x 12 = $960,000. Let’s say the total operating expenses for the property are $480,000, a 50% expense ratio.
This would give us an NOI equal to $480,000: $960,000 – $480,000 = $480,000. With an NOI of $480,000 and a purchase price of $8,000,000, the purchase cap rate is 6% (NOI/purchase price).
Now here comes the “magic” part: Over the next 18-24 months, you renovate the interior of the units by replacing the cabinets, adding a fresh coat of paint, updating the countertops and appliances, upgrading fixtures, laying new flooring, etc. You also give the exterior a facelift with fresh paint and landscaping.
As you complete the renovation of the units, you start leasing them at the market rate, which, in this case, is around $1,000 per unit. The new income is 100 x 1,000 x 12 = $1,200,000. Assuming operating expenses are still at 50%, the NOI now is $600,000. Assuming the cap rate remains the same, the new valuation of the property based on the formula above is $600,000 / 6% = $10 million.
Remember, you bought the property for $8 million, put in $1 million of capital expenditure and were able to raise the property value to $10 million within 24 months.
Abracadabra? Not really … just smart investing.