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 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.
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.
Photo credit: cogdogblogManufacturing Equity in Multi-Family Properties with The Rule of 150 by Andrew C. MacDonald