Multifamily Myths: Why You Don’t Control The Value Like Everyone Says You Do
When investing in single family homes, you have to sit around waiting for the market to appreciate to realize a higher value. When you own an apartment complex, you are in control. If you want the value to go up, all you have to do is raise rents and/or cut expenses. You’ll sometimes hear this called “forced appreciation,” and it’s so easy even a kid can do it. Or is it?
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If you read my “Multifamily Myth” article on why multifamily is easy to value, you already know that multifamily is valued by calculating the Net Operating Income (NOI = income minus expenses) that the property generates and then dividing that income by the capitalization rate (Cap Rate). By virtue of the very nature of the calculation, it’s easy to see that raising the income would correspondingly raise the value. Thus, the myth is born that you can force the value by increasing the income or decreasing the expenses.
Raise the Income… But Can You?
Now, you know that there are two sides to the approach. Let’s begin with the income side. Increasing the income is easy—just raise the rent. Not so fast… your ability to do that is limited by the market. What are similar properties charging? Raising the rent will not raise your income if the apartments are empty.
If there is room in the rents, go for it. You should be charging market rates or you’re leaving money on the table. But there are other ways to increase income. One is to rent more apartments. Perhaps you need to spend more money on marketing to attract more tenants and fill your vacancies. Maybe you need a staged model unit to create an emotional reaction to rent units faster and perhaps for higher rent.
Another option is to charge back for utilities if you aren’t doing that already. Check your local laws about the limitations on doing so, and if allowed and the market will support it, you should be charging.
The most important thing in all of the above is the market. You can neither raise rents nor charge for utilities if you are already getting all the market will bear. It’s not as simple as just raising the income because you want to increase the value. When you hear people say that single family homes are at the mercy of market appreciation, realize that you are in the same boat with multifamily property—but the “market appreciation” that rules the day is appreciation in rental rates rather than home values. The bottom line: It is the market that raises the income, not you. Your job is just to facilitate it.
Lower the Expenses? Not So Fast!
So we all agree that raising the income has market-based limitations (we do agree, right?). But don’t despair; you can also raise the NOI by reducing expenses. Or can you? And if you do, will it matter?
Let’s start with “can you?” Sure, you can lower the expenses, but you’d better be prepared for the consequences if you cut the wrong ones or cut too much. Have you ever seen a broker’s pro forma showing $600 per unit per year payroll? If you’ve never owned a multifamily property, you might think this is ok, but experienced owners know otherwise. I suppose that if your unemployed relative (admit it…we all have one) were to run the place, you might get a break on the payroll—but if you hire a qualified employee and the right number of employees for the size of the property, it’ll cost you. Don’t let this be a surprise that catches you after acquisition, either. Plan for it in advance in your underwriting. You’ll pay somewhere between $1,100 and $1,300 per unit per year for payroll (or perhaps even more) depending on the property class, the area’s prevailing wages (think “cost of living”), and the size of the property (smaller properties have fewer units with which to amortize the cost).
Cut your payroll expense too far, and you’ll either have a lot of employee turnover (not good) or an understaffed property (worse). You can spot an understaffed property from the street; just look for the deferred maintenance. And as soon as you walk in the door of the office, you’ll immediately see further evidence of a property skimping on payroll.
Ok, forget payroll. Where else can you cut? How about marketing? This one is easy—simply stop running so many ads. Drop your website advertising campaigns. Stop working with apartment locators. Just rely on good old free classified listing sites. It’s very simple and straightforward… until your traffic starts to thin, leasing velocity drops, and vacancies increase. Now you’re offering concessions to get tenants to sign a lease or keeping your rents below market so that people will be attracted to you because of cheap prices rather than stellar marketing. Well, I guess this solution is out the window.
If you can’t cut payroll or marketing, you can surely cut administrative expenses, right? Use cheap property management software. Have fewer phone lines. Buy discounted copier toner. Don’t buy uniforms for your staff, just have them wear their street clothes. Be careful here, though. Lacking a professional look, callers getting busy signals, and having crummy rent rolls that no one can decipher might be cheaper, but that doesn’t make it better.
Do Expenses Even Matter?
Does it even matter? If you reduce your expenses, will you increase your property value? If you simply follow the formula of NOI divided by cap rate, it sure does matter. Appraisers to this, so if you are refinancing, cutting expenses matters. But let’s remember—in real estate investing, you make your money when you buy and you get paid when you sell. So what really matters is whether decreasing expenses increases the value in the sense of whether your buyer will pay you more for your property. Will they? Yes and no.
Professional buyers of income property don’t care much what your expenses are. They care what their expenses will be. Their expenses will be different than yours. In other words, I don’t care if you are running your property with $800/unit payroll. I know that it costs $1,200, so when I’m deciding how much to pay you for your property, I’m putting $1,200 in my model. All of that hard work skimping on payroll, dealing with subpar employees, being understaffed, and constantly dealing with employee turnover brought you nothing on the sale. I call that a sale fail. Same goes with property management, administrative costs, insurance, property taxes, repairs and maintenance, and marketing. I’ll use what I know from experience it will cost me to run your property, not what you’ve been spending.
But There is Hope…
Yes, you can make a difference—both to an appraiser and a buyer. There are two primary areas of focus: Utilities and contract services. Let’s start with utilities. As a buyer underwriting an acquisition, one of the few expenses I take at face value is the utilities expense. Reduce this, and you can see true forced appreciation. How? Install more water efficient plumbing fixtures. Landscape with less thirsty foliage. Bill back water expenses to tenants to encourage conservation. Shop around for better electric rates or install a solar system for the office and pool. Replace old, inefficient boilers with new, high-efficiency ones to cut your gas bill. I did this at one of my apartment complexes last year. It cost me $25,000, but it cut my gas bill by over $1,000 per month and got me another $150,000 when I sold it this year. How’s that for return on investment?
What are contract services? This includes your landscape maintenance contract. The trash hauler. Security patrol. The pest control contract. Essentially anything that you contract out on a recurring basis at a fixed or semi-fixed cost (not to be confused with contracted labor, which is repair work handled by outside contractors—that’s in the repair and maintenance column but frequently misallocated). You can realize savings here by negotiating the best prices and using the forces of competition amongst vendors to get the best prices. These service contracts can be assumed by the buyer, and thus buyers typically take these expenses at face value, and less expense means more value.
Cutting Expenses Can Help Even Without Forced Appreciation
Forcing appreciation isn’t the only reason to cut expenses. There are ways to cut expenses without sacrificing the operations and performance of the property. These won’t likely give you any additional value, but they’ll give you more cash flow. They are:
- Challenging your property tax assessment. We all can agree that lowering taxes is good for cash flow.
- Containing insurance expenses. Shop around and get the best rates; just be careful when skimping on policy limits and playing with deductibles, as this can come back to haunt you.
- Monitoring vacant unit electric. Make sure that you are switching off the lights and not running the heat and AC unnecessarily in your empty units.
So what about the myth of forced appreciation? Is it real? I’d argue that it is, but it isn’t as easy as some may lead you to believe. And no matter what, you are still a slave to the market, like it or not.
Let me know your thoughts with a comment.