Increase your Property Value with Forced Appreciation
One huge advantage of investing in buy & hold properties is the opportunity to gain value through efficient and effective property management.
Rental properties are valued based on the income they generate. That is, the market does not consider emotional attachment or personal preference when putting a value on a rental property. All that matters is the income generated and the time and effort that one must allocate to optimize this income generation.
Make your Money Going In
The point cannot be emphasized enough: You will only succeed in real estate if you learn to properly analyze and purchase properties. The common idiom is “You make your money going in”. That is, if you don’t purchase at the right price and under the right turns, you’ll be constantly fighting with your property to yield a positive financial return.
Ensure that your property will meet your financial objectives in its current state. Unless you are planning major renovations, consider the actual financials as the only source of truth during your analysis process. Do your best to avoid using pro-forma figures or future projections banking on an upturn in the market. You should make sure that your worst case scenario is still a scenario that yields a financial profit. It is fine to perform high level forecasts to determine your potential upside, but do not make a purchase decision that relies solely on this potential upside. The bottom line is that the only source of fact is current financials. Even if you have high confidence in your forecast, they will never have 100% assurance that they will be realized.
When negotiating the purchase of a rental property, it is essential to establish strict buying criteria and stick to your guns. You must let the numbers do the talking and remove any emotional attachment you may feel. Forget about the pride you might feel from buying a property in a desirable neighborhood. This pride is worthless if your property does not make money. Its a lot more fun to feel proud of your properties that are making passive income while you sleep.
Simple Algebra Shows us how to Force Appreciation on our Rental Properties
When it comes to increasing the value of your rental properties, you need not look any further than the rudimentary algebra skills you learned in high school.
If you are properly analyzing your potential purchases, you are surely familiar with the metric of Capitalization Rate. As a reminder, the calculation is shown below:
Capitalization Rate = Annual NOI ÷ Property Value
Put simply, Capitalization Rate, or Cap Rate, is the return at which an investor would deploy capital. Each unique market will warrant different Cap Rates. However, most market Cap Rates fall in the range of 8%-12%. Knowing your market Cap Rate is essential to properly valuing income properties. You can determine the Cap Rate for any market by simply studying historical data and speaking with other investors and real estate agents. Once you know your market Cap Rate, we can rearrange our Cap Rate formula to better understand how we can take action to increase the value of our Rental Properties.
As an example, assume you are considering the purchase of a 4 unit rental property property.. You verify the property financials and determine that the Annual NOI is 39,000. With an asking price of $325,000, the seller is trying to sell at a Cap Rate of 12%. Is 12% within the acceptable range for your market? If its too low, you do not want to purchase this property unless you can get a significant discount off the list price.
No matter what Cap Rate you purchase at, your goal is to raise the property value after you make the purchase.
This simple formula has 3 and only 3 variables. Your market capitalization rate is constant and out of your control. As an investor, its your job to influence the Annual NOI thereby influencing the overall Property Value.
The first step is to isolate the Property Value within the Cap Rate formula:
Property Value = Annual NOI ÷ Capitalization Rate
It is now clear to see that the value of your property is a direct function of Annual NOI and Cap Rate. As mentioned, we can’t do anything about the Cap Rate. However, we can always influence the NOI. Cap Rate being constant, an increase in Annual NOI will increase the value of your property.
Assume we make the purchase mentioned above. We buy the 4-unit property for $325,000 and in the first year the property has an NOI of $39,000. The 12% Cap Rate is exactly the market average for this specific area and for this specific property type. If we can find a way to increase the Annual NOI, we will, in effect, raise the value of the property.
For example, what if the previous owner was charging rents that were below market value? After taking ownership and instilling our business and property management processes, we will in turn raise our rents by $100/ unit. All else being equal, the increase in rent will result in an increase in the Annual NOI of $4,800. Based on our Property Value formula above, we have just increased the value of our property by $40,000!
Property Value = 43,800 ÷ 12%
Property Value = $365,000
Increasing your NOI can be done by doing one or both of the following: Increasing Revenue or Decreasing Operating Costs
- Raise Rents
- Reduce Vacancy Rates
- Add Supplemental Sources of Income (Laundry, Parking, etc)
- Charge for other Amenities
- Manage energy usage for common utilities (use timers, sensors and thermostat covers)
- Negotiate more favorable prices with vendors (lawn care, snow plowing property management)
- Be proactive with repairs & maintenance
- Purchase materials and supplies in bulk
Why we want Higher Property Values
You may be wondering why it matters so much that we increase the value of our property after we make the purchase. The simple answer to this is so that we are looking to enhance our equity position in our property. The amount of outstanding debt will not increase if you increase the value of your property. Therefore, you will have a higher percentage of equity resulting in the increased value.
This increased property value allows an investor to restructure his financing to tap the augmented equity position. We could make use of a line of credit using the added equity as collateral for the loan. The increased value will obviously help an investor on the tail end of the deal as well. When you go to sell your property, potential buyers will use your increased NOI figures to perform their analysis. Cap Rate remaining constant, your property will warrant a higher sale price.
The important takeaway is to understand that you are in control of your property value. As the owner, you have the ability to make adjustments that will in turn increase your NOI.