How to Increase Investment Value by Increasing Rental Income
I started investing in real estate in late 2008 utilizing the typical investment strategies associated with buying discounted and/or distressed assets that were either short sales, lender owned or seller liquidations. It has taken me over four years to realize that you could invest in real estate at its current market value and still make an additional 20%+ growth in asset value over an investment holding period! “Real Estate Value Add Investing” is the way to do it and I will share some of my strategies and ideas over the course of the next four articles.
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Real Estate Value Add investing is a proposition wherein you buy properties at or below market value and still increase their value by 20% or more utilizing value add improvement centers that the seller was not able to tap. The key formula to remember when executing value add strategies is as follows:
Feasible Strategy = Value Add Increase > Cost to Make the Increase Happen
Hence it is important that that the value of the increase you seek either costs nothing or the cost is smaller than the resulting value increase for the strategy to be feasible value add strategy.
How to Find Value Add Centers in a Property?
Every property has changeable and unchangeable characteristics. As a value-add investor you want to find properties with good unchangeables i.e. location, lot size and easily rectifiable changeable characteristics. My list of changeable real estate value centers is as follows (this is not comprehensive and there are other value add centers; if you have any other centers please leave them in the comments below):
- Rental Income Quality and Sources
- Expense Sources & Relative Costs
- Load Factors of a building
- Barrier to Entry laws such as rent control, zoning and environmental
- Highest and Best Use Mismatch
Over the course of the next few articles, I will go into each value center and how you can create an investment strategy surrounding it within your target investment markets. Today I will start with Rental Income Quality and Sources (strategy will discuss multifamily as an asset class but the ideas are transferable to any asset classes in my personal opinion):
Strategy Name: Rental Income Quality and Sources
Asset Types: Income Oriented Assets i.e. Multifamily, Office, Retail, Self Storage etc.
Goal: The goal of this strategy is to increase the quality and sources of the rental income being produced at an investment asset to help increase the investments cashflow and relative asset value.
Theory: The theory behind this strategy arises from the fact that the value of an income property is based on its income stream divided by a target capitalization rate. A capitalization rate (cap rate) is defined as the property’s net income divided by its value:
Income = Rate x Value
So turning around that formula to solve for value would be as follows:
This formula indicates that higher your increase the net income stream of an asset the higher its value will be become even if the cap rate held steady.
Here is an example of this idea: a property with a $50,000 net income at a 10% cap rate would be worth $500,000. That same property with an income stream of $55,000 at the same 10% cap rate would be worth $550,000. This example shows how powerful a $416 per month net income increase can mean in terms of asset value growth.
Strategy Defined: The strategy is two-prong in nature as it involves raising the rents of a income property up to market value while locating additional cashflow centers.
Acquisition Targets: Seek out income properties where the rents are currently below market value and you have the required skill set as discussed below to bring the rents up to market value.
Target Markets: Locate markets with vacancy rates below 5% (caveat to this rule of thumb is that it depends on which market you are in as in NYC the market will always be below 5% but locating profitable opportunities will be tougher) and where rent control is non-existent or has a provision for vacancy decontrol.
You can utilize vacancy rate analysis to locate such markets. A vacancy rate analysis can be easily completed by acquiring asset specific research reports from sources such REIS, Co-Start, Loopnet, or from Realtor organization such as Marcus & Millerchap, CBRE etc.
Skills Needed: Acquisition Sourcing
Negotiation and Lease Analysis
L-T (Landlord-Tenant) Attorney
Tenant Buyout Equity Capital
Acquisition Math: To figure out what to offer and whether the building works from an investment feasibility standpoint:
You need to a complete fair market value analysis of the rental income within your located investment market. Then you need to figure out what is the value-increasing proposition that you are seeking; is it 20% or 30% or a 40% increase in asset value (this number which can be a function of your cost of capital or your own target yield). To help clarify this concept lets review an example below:
Rental Market Value Analysis
|1 Bedroom||$750||30 days on market|
|2 Bedrooms||$1,000||15 days on market|
|3 Bedrooms||$1,250||29 days on market|
Value Increasing Proposition Target: 20%+
Asset Type: 2 bedroom units only as they rent the fastest compared to all other units.
Given the information above, you will need to locate a building with all two-bedroom apartments where in-place rents are at or below $833 per month with month-to-month tenants only. How did I get to this number?
$1,000/(1+20%) = $833
Hence locating a building that is currently producing less than $833 per unit per month will give you the requisite opportunity to increase the rental income to your target value-increasing proposition.
Execution: Executing and managing the turnover are the biggest hurdles to implementing this strategy successfully. The key pointers that I can give to successfully executing this strategy are as follows:
- Determine your property breakeven occupancy level prior to taking title.
- Immediately after closing title, send out rent increase notices subject to the rental laws of your target investment municipality to all tenants above your breakeven occupancy level. The receipt of these notices may cause your tenants to stop paying rent and thus forcing you to complete tenant evictions or buyouts.
- If the tenants do not respond to your rent increase notices or stop paying rent then have a meeting with them and offer to buy them out of their leasehold interest.
How much should you spend buying out below market value tenants? That is a question that I wanted to figure out when I started using this strategy. I came up with a 2 year payback period rule that has given me a good rule of thumb:
One way of figuring that number out is a 2-year payback principle wherein you calculate what the increase will yield you across a 24-month investment horizon. In our example above a $167 increase across 4 units would equate to $ $16,032 with a variance associated with non-rent payment by new payments. A 25% variance would allow you to spend up to $12,000 for kick out/buyout costs equating to appx $3,000 per unit. How much of that budget you actually spend will depend on your negotiation skills as a real estate investor.
- As soon as the tenants are out the units, complete a through clean out of the trash and cleaning of the unit and very minor cosmetic updates if needed and rent out the unit for a target $975 to 990 per unit. Remember the goal is to get it up to market value without doing a lot of work to unit.
Is this strategy even worth it?
Well let’s test out the math. If you increased the rental income of each unit by $125 on the low side across 4 units that would equate to $6,000 per year thereby creating $60,000 in asset value at a 10% cap rate.
Risks: All strategies carry risks and this one is no exception. Here are the risks surrounding this strategy:
*Lack of CashFlow- As you evict or buy out tenants; your investments cashflow profile will be highly diminished for a period of time. Hence you should not evict or send out rent increase notices to all tenants at the same time rather you should send out notices/buy out a percentage of tenants above your breakeven ratio.
*Legal Issues- As you send out rent increase notices, a tenant may drag you in front of a rent control board and/or a judge. Have a good L-T lawyer as a part of your team and make you only send a rent increase notice that is within the allowable increase of the municipal ordinance.
Rental income quality & sources value add strategy is a great method to increase asset value through locating under valued rental income asset. Utilize this strategy in your investment strategies tool box as you look at your next deal as you may seem an opportunity that another real estate investor misses.
Photo: Jeremy Levine Design