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Manufacturing Equity in Multi-Family Properties with The Rule of 150

by Andrew C. MacDonald on June 20, 2011 · 10 comments

  
manufactured equity real estate

This weekend I attended a Multi-Family Investing Bootcamp organized by The Real Estate Investment Network (REIN) and started to learn about how to acquire, manage and exit multi-residential properties. One of the key takeaways for me was the rule of 150 which I will explain here. There are some differences in the way single family and small residential properties are valued when compared against multi-family properties and this creates a powerful opportunity to create equity by increasing a building’s value.

What is the Rule of 150?

The rule of 150 applies to improving the operational profitability of a multi-family property. For each additional $1 in monthly NOI (Net Operating Income), the value of the property is increased by approximately $150. This increase in NOI can come by either increasing income or decreasing expenses.

Why It Works

Unlike small residential properties of 4 or fewer units where value depends on comparable homes, multi-family valuations are primarily a function of the Capitalization Rate. This difference in valuation method means improving the financial operation of a building will also improve it’s value and lead to increased equity. If you don’t know what NOI or Capitalization Rates are, I’ll explain next.

The Math

The simple formula for Capitalization (or Cap Rate) is:
Capitalization Rate = NOI / Building Value

NOI is simply income less operating expenses (this excludes debt servicing costs) and by increasing income or reducing expenses. Because the capitalization rate is typically set for each city or region, by changing NOI, you change building value.

The rule of 150 assumes an 8% capitalization rate. This may be higher or lower in your area, but here is how the math works.

We can rearrange our capitalization rate formula to Building Value = NOI / Capitalization Rate. If we increase our NOI by $1 per month, this is equal to an increase of $12 per year. This $12 annual increase in NOI divided by our 8% cap rate leads to an increase in building value of $150.

So in simple terms, $1 per month x 12 months per year / 8% cap rate = $150 increase in building value.

Examples

Let’s take a quick look at a couple of examples of how this can be put into practice.

Example 1 – Increasing Rent

Increasing rent can be as simple as bringing existing rents up to market level, or can be forced upward by improving the property. For example, by adding a dishwasher we may be able to rent a unit for an extra $10 per month. Using the rule of 150 this translates to a $1,500 increase in building value. If the dishwasher cost was $500, you’re ahead of the game by $1,000. Do this to every unit in a 10-plex and you’ve just added $15,000 in value or $10,000 in profit. By bringing rents up to market value and making some small improvements you can create a significant amount of equity in multi-family buildings

Example 2 – Decreasing Expenses

Another way to improve NOI is by decreasing expenses. One of the easiest ways to do this is to decrease electricity costs by using energy efficient lighting. Replacing light bulbs in a multi-family building is one the best ways to reduce expenses and has an almost immediate payback. Using the rule of 150, there are several ways to improve NOI by reducing expenses.

Whether you add income or reduce expense, just remember a $1 increase in NOI translates to $150 in equity at an 8% cap rate. Just crunch the numbers at your local cap rate and see where you can cut expenses or make smart upgrades that will reward you handsomely. This is a great way to create value in multi-family investing.

Creative Commons License Photo credit: cogdogblog

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{ 9 comments… read them below or add one }

Alex Aguilar June 20, 2011 at 3:27 pm

This NOI capitalization stuff is fascinating. On paper it makes perfect sense and sounds completely reasonable to increase rent or cut down expenses for much higher returns on residential properties, but I have to wonder if this stuff actually works out as planned in the real world. Maybe you could do a blog with a real world case study that demonstrates the Rule of 150?

Reply

Andrew C. MacDonald June 21, 2011 at 7:15 pm

Hi Alex, In multi-family properties the valuation is based math (NOI and Cap Rate) rather than comparable homes in the area so an improvement in NOI directly impacts value. The examples I provided are quite realistic and many of the multi-family experts who presented at this event use The Rule of 150 to increase building value and realize substantial returns.

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Rob Viglione June 21, 2011 at 8:24 am

Rule of 150 is good rule of thumb, but also changes with market cap rates. Markets don’t always value cash flows the same, it’s like fluctuating PE’s in stocks.

Also of note is the cost of obtaining higher NOI by increasing rents; you’re either improving the property (costs $$$), or increasing vacancy risk, which also has a cost.

Reply

Andrew C. MacDonald June 21, 2011 at 7:18 pm

Hi Rob, As you mention the Rule of 150 only holds true at an 8% Cap Rate but you can use the same math to determine a value multiple at any cap rate. With improvements you need to do the math using the cap rate in your area to determine where your money will be spent wisely and this also depends on your exit strategy for the property. The nice thing is that sometimes all you need to do is bring rents up to market rate to realize a signifcant improvement in NOI, but you make a good point about increasing vacancy risk by doing so. As always we have to weigh our options and make smart decisions.

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Rob Viglione June 21, 2011 at 7:41 pm

Good points. I do think we have a period of good rental growth rates ahead of us, combination of inflation and limited access to credit markets for multitudes of people who were caught on the wrong side of the housing crash. So NOI should see good boost across the board for multi-unit residential.

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Joel Owens June 26, 2011 at 10:41 pm

At any event they always make it sound easy.I specialize in multifamily.

Multifamily is a hard business.I know from all the tired landlords who have me list their properties.Having said that most of the value is in B to C class buildings in A to B areas.

A typical investor will not go after new development or compete with a REIT for a brand new A class property.Here in my area of the U.S. B age properties are about an 9 CAP.C age properties command a 10 to 11 CAP or higher.

Financing is the biggest issue in Multifamily.If a buyer has 1 million dollars they want to leverage it out and purchase 10 deals with 100k down versus putting it into 2 to 3 deals.Buyers try to get in little to no money down having the seller hold back a second and put 10 percent down making the 1st position lender loan at 75% LTV.

You can use hard money for value add deals but the investors want to refinance out as a soon as possible to get a better cash flow from lower dent service and get more money to pursue more deals.

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Andrew C. MacDonald July 5, 2011 at 12:06 pm

Hi Joel, to me it seems like more work because of the amount of due diligence and the tenant profile to be managed. Financing is a larger hurdle when compared to single family homes or smaller properties, but there are some nice economies of scale that make it appealing. I think buying worse buildings in better areas is the best strategy, leave class A to the REITs.

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David June 27, 2011 at 9:11 am

Thanks for the article. What I (and I’m sure others) would find useful is a detailed dive into various techniques for managing and reducing expenses in a range of sizes of multi family properties (from 4-unit up to 200-unit, beyond that it’s more institutional players), including optimal property mgmt practices (when to have on-site managers and maint. people at various size buildings, how to compensate them, etc.), utilities mgmt, lease provisions to incent tenants toward optimal behavior (i.e. taking care of your unit to reduce repair/turn costs), finding the best and cheapest insurance coverage, negotiating or bartering with contractors for best rates, techniques to reduce turnover and maintain good tenat relations, etc.

On the revenue side, discussions around the rent-enhancement value of various specific upgrades you might make to your property, optimal advertising and tenant lead generation, most effective and cost-efficient “wow” factors to add to your units and premises, etc.

Thanks.

Reply

Andrew C. MacDonald July 5, 2011 at 12:09 pm

Hi David, what you propose sounds like a great idea for some of the other authors with more multi-family experience. I am still playing the single family game at the moment so my knowledge on these specifics is limited.

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