The number one goal when investing in multifamily real estate is to increase the Net Operating Income (NOI). NOI can be defined as the total gross revenue subtracted by the operating expenses of a property. A cap rate is simply the rate of return on an asset based on income. The higher the NOI, the higher the value of the asset.
Cap rates are primarily used in commercial real estate and are one metric used to establish a property’s value. Cap rates fluctuate from market to market and property type, so it is imperative that you become familiar with cap rates in your market. We use cap rates in conjunction with cash on cash returns and debt coverage ratio to analyze the purchase of a property. Your broker should be able to provide you with market cap rates.
How do you calculate the value with cap rates? Let me show you a quick calculation. Let’s assume the NOI of a property is $200,000 and the prevailing market cap rate is 10. You would take the NOI and divide the cap rate to obtain the market value. Thus $200,000/.10 = $2,000,000 value. Market value and cap rates have an inverse relationship. As cap rates lower, values rise and vice versa.
If the NOI on the same property increased to $220,000, the value of the asset at a 10 cap would increase to $2,200,000. As you can see, a $20,000 increase in the NOI boosts the value of the property by $200,000. Your focus in multifamily is squarely on increasing the revenue or decreasing the operating expenses of the property. I call this forced appreciation because you have the ability to increase the value of the asset through exceptional management.
Let us illustrate our three-step framework on expanding the NOI.
Step #1: Fill the vacant units.
Once you take over the property, your number one priority is to lease up the vacant units. You should already have a concrete idea of what market rents are. Our preferred tool to use when analyzing market rents is Rentometer. It is an invaluable tool to compare rents in the market and will tell you if your rent is reasonable, too high or a good deal. It also depicts other rentals in your area. Their resource center is also loaded with essential services and products for landlords and investors.
If you have a real estate broker as a team member, you can have him prepare a comparative market report for you. Have him collect the market rents of all rentals within a 20-minute radius of your property. This analysis is always performed as part of your due diligence when purchasing the property to see if there is any upward mobility to rental increases. Once you take over, continue at least quarterly to monitor rents in the area.
A couple other strategies to implement: Visit Craigslist and other rental sites to analyze current rents, and Google your property and visit all complexes near your property to analyze rents. Jake and I also pick up the phone and call the competition to see what they are charging and what amenities they offer.
Some investors may be intimidated by properties that contain an above average vacancy. It may be due to market factors, such as demand or low job growth. Our experience has been that most of the vacancy was due to poor management and poor marketing of the property.
We quickly establish a website and market our property online through Rentlinx andApartments.com. We are now testing the market with targeted Facebook ads. The strategy is to target individuals living within a five-mile radius of the property and deliver ads to them. We also begin to deliver top quality service to our customers, the tenants. These two variables allow us to fill up the vacant units quickly.
Step 2: Implement RUBS
You may be asking yourself, “What is RUBS?” Also known as ratio utility billing system, RUBS allows landlords to bill back a portion of the utility expense to the tenant. RUBS can comprise water, sewer, electric and garbage. It allows the landlord to implement the system with no capital expenditure and is a very fair system to implement when sub-metering is not possible. It can be based on certain factors — square footage and number of occupants are the most common.
We target properties where landlords overlook this source of revenue. Why would some landlords ignore this simple system? I think there are a couple of reasons. First of all, landlords are simply too lazy to try something new. Ever heard of “if it ain’t broke, don’t fix it”? In this case, it’s time to break it.
Secondly, many landlords have not kept up with their education and continue the status quo. We have also seen that landlords feel that tenants will vacate the property if they are charged for their utilities. The only instance where this will happen is if your competition is not using RUBS on their properties.
We are fortunate that in our market, it is common practice to bill back the tenants for usage. I recommend visiting NWP for more information on how to implement a system for your property. Our plan has been to bill the tenants $30 per month for utilities. We are not recouping the entire portion of the utility expense, but more importantly, we are not exceeding 100% of the utility expense. Moreover, the rest of the market has set the rate at that dollar amount, and we feel comfortable charging this amount.
Let me illustrate the power of RUBS. We took over a property with 136 units that were not billing back the tenants. We decided to charge the tenants $35 per month for utility. Most of the tenants were on a lease, and we had to wait until the lease expired to begin billing. Once the entire tenant base was switched over to RUBS, the results were extraordinary. We were able to generate an additional approximately $50,000 per year in revenue. More importantly, the NOI increased by that amount, and the value of the asset increased by $625,000 (based on an 8 cap — $50,000/.08).
Step 3: Raise remaining tenants to market.
Now that a lot of the heavy lifting has taken place, it’s time to reevaluate the market and begin to increase the current tenants to market. Don’t forget to use the website Rentometer to gauge current market rents. At this point, the tenants have seen a transformation at the property. The exterior has been painted, the common areas are attractive, the maintenance staff is very responsive, and overall customer service has skyrocketed. Now it’s time to start raising the remaining rents.
Our strategy is to choose a few units to begin the process. This is where you have to test the market and see if your property will sustain these rental increases.
One note: We have had very little resistance to rent increases when we followed our three-step strategy. Some tenants will complain about the increase. Let them vent their frustrations and search for another apartment. When they calm down, they will realize the deal they’ve had the past few years and that renting another apartment will cost them as much as what you are going to charge them.
Once we’ve accomplished our goal of increasing the NOI, the fun begins. We approach banks and commence the process of refinancing the property. It normally takes us about 12 months to reposition a property and extract the equity from it. Banks usually expect to have 12 months of profit and loss figures to establish an accurate appraisal of the property.
Let me give you an example of one of our purchases that led to a refinance. The complex was purchased for $4.075 million with $53,000 per month in income. We quickly realized that the property was underperforming due to poor management. We were able to grow the income of the property to over $80,000 per month within the first year.
The problem we encountered was that banks were confused with how we were able to reposition the asset so quickly. This confusion and denial led to unimpressive appraisals. After working with two lenders, we finally struck gold with a portfolio lender who was willing to offer us great terms and accept a $6.33 million appraisal. We were able to extract $1.6 million of equity from this one deal.
Step 4: Implement DoorStep Trash Service.
This is what I refer to as icing on the cake. You'll still control the asset with no money in the deal, and the property continues to grow cash flow thru NOI generated from Valet Trash Service from NationalDoorstep.com. Owners and Operators consistently earn a Cap Rate of 6-8%. This was all possible from acquiring an asset that was underperforming and then concentrating on raising the NOI.
Begin to focus on the NOI of a property. Look for value-adds, such as increasing the rents, filling any vacant units, and implementing a utility bill back system. Purchase the property on actual 12-month profit and loss figures. NO pro formas! The goal of any real estate purchase is to create value. The more value you create, the bigger your paycheck. Create a game plan from day one of takeover and execute once you become the new owner. Failing to plan is planning to fail.
Investors: Any questions about this process? What have you done to raise the value of your multifamily?