{"id":74870,"date":"2015-09-13T05:00:40","date_gmt":"2015-09-13T11:00:40","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=74870"},"modified":"2021-03-16T11:44:52","modified_gmt":"2021-03-16T17:44:52","slug":"2015-09-13-multifamily-myths-dont-control-value","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/2015-09-13-multifamily-myths-dont-control-value","title":{"rendered":"Multifamily Myths: Why You Don\u2019t Control The Value Like Everyone Says You Do"},"content":{"rendered":"

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\u2019ll sometimes hear this called \u201cforced appreciation,\u201d and it\u2019s so easy even a kid can do it. Or is it?<\/p>\n

If you read my \u201cMultifamily Myth\u201d article on why multifamily is easy to value<\/a>, 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\u2019s 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.<\/p>\n

Raise the Income\u2026 But Can You?<\/h2>\n

Now, you know that there are two sides to the approach. Let\u2019s begin with the income side. Increasing the income is easy\u2014just raise the rent. Not so fast\u2026 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.<\/p>\n

If there is room in the rents, go for it. You should be charging market rates or you\u2019re 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.<\/p>\n

Another option is to charge back for utilities if you aren\u2019t 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.<\/p>\n

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\u2019s 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\u2014but the \u201cmarket appreciation\u201d that rules the day is appreciation in rental rates rather than home values. The bottom line: It is the market<\/strong> that raises the income, not you<\/strong>. Your job is just to facilitate it.<\/p>\n

Related:<\/strong> Multifamily Myths: Why Economy of Scale Doesn\u2019t Mean What You Think it Does<\/a><\/em><\/p>\n

Lower the Expenses? Not So Fast!<\/h2>\n

So we all agree that raising the income has market-based limitations (we do agree, right?). But don\u2019t despair; you can also raise the NOI by reducing expenses. Or can you? And if you do, will it matter?<\/p>\n

Let\u2019s start with \u201ccan you?\u201d Sure, you can lower the expenses, but you\u2019d better be prepared for the consequences if you cut the wrong ones or cut too much. Have you ever seen a broker\u2019s pro forma showing $600 per unit per year payroll? If you\u2019ve 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\u2026we all have one) were to run the place, you might get a break on the payroll\u2014but if you hire a qualified employee and the right number of employees for the size of the property, it\u2019ll cost you. Don\u2019t let this be a surprise that catches you after acquisition, either. Plan for it in advance in your underwriting. You\u2019ll 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\u2019s prevailing wages (think \u201ccost of living\u201d), and the size of the property (smaller properties have fewer units with which to amortize the cost).<\/p>\n

Cut your payroll expense too far, and you\u2019ll 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\u2019ll immediately see further evidence of a property skimping on payroll.<\/p>\n

Ok, forget payroll. Where else can you cut? How about marketing? This one is easy\u2014simply 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\u2019s very simple and straightforward\u2026 until your traffic starts to thin, leasing velocity drops, and vacancies increase. Now you\u2019re 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.<\/p>\n

If you can\u2019t 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\u2019t 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\u2019t make it better.<\/p>\n

Do Expenses Even Matter?<\/h2>\n

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\u2019s remember\u2014in 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.<\/p>\n

Professional buyers of income property don\u2019t care much what your expenses are. They care what their<\/strong> expenses will be<\/strong>.<\/em> Their expenses will be different than yours. In other words, I don\u2019t care if you are running your property with $800\/unit payroll. I know that it costs $1,200, so when I\u2019m deciding how much to pay you for your property, I\u2019m 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\u2019ll use what I know from experience it will cost me to run your property, not what you\u2019ve been spending.<\/p>\n

But There is Hope\u2026<\/h2>\n

Yes, you can make a difference\u2014both to an appraiser and a buyer. There are two primary areas of focus: Utilities and contract services. Let\u2019s 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\u2019s that for return on investment?<\/p>\n

Related:<\/strong> Multifamily Myths: Why Inexperienced Investors Think They Can Raise a Million Dollars<\/a><\/em><\/p>\n

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<\/strong> labor, which is repair work handled by outside contractors\u2014that\u2019s 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.<\/p>\n

Cutting Expenses Can Help Even Without\u00a0Forced Appreciation<\/h2>\n

Forcing appreciation isn\u2019t the only reason to cut expenses. There are ways to cut expenses without sacrificing the operations and performance of the property. These won\u2019t likely give you any additional value, but they\u2019ll give you more cash flow. They are:<\/p>\n

    \n
  1. Challenging your property tax assessment. We all can agree that lowering taxes is good for cash flow.<\/li>\n
  2. 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.<\/li>\n
  3. 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.<\/li>\n<\/ol>\n

    So what about the myth of forced appreciation? Is it real? I\u2019d argue that it is, but it isn\u2019t 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.<\/em><\/p>\n

    Let me know your thoughts with a comment.<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"

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