Real Estate “Value-Add Investing” is a proposition wherein you buy properties at or below market value and still increase their value by 20%+ by identifying and exploiting value add improvement centers that the seller was not able to tap. In the last article I wrote, we discussed how to increase the value of your investment through rental income growth techniques. This article we will look into the flip side of the equation and see how you increase your investment value through expense compression.
The value add formula to determine the feasibility of executing any value add strategy is the same as the last article. Lets just review it once again:
Feasible Strategy = Value Add Increase/Savings > Cost to Make the Increase Happen
The formula from the perspective of expense reduction relates to how much money is saved in comparison to the upfront cost to reduce or remove the expense category.
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What Expenses to Reduce?
Every property has operating expenses that directly impact the property’s net operating income. Typically operating expenses combine to total approximately 55% of a properties gross income. Hence reducing operating expenses is a great way to increase property net operating income and its associated resale value. That is the big picture that you should keep in mind as you go after and identify expense reduction centers.
Operating expenses typically fall into one of two categories: verifiable or non-verifiable expenses. Verifiable expenses are those that you will incur on a repeat basis and it can be verified by a third party i.e. property tax, utilities. The expense compression value add strategy surrounds reducing verifiable expenses since when you go to sell the investment property; the prospective buyer will only give you credit for this category of expense reduction.
Major Verifiable Expense Sources
The main center of verifiable operating expense is property taxes and working to reduce that expense will help you increase cash flow and in turns asset value.
Expense Center – Property Taxes
Property taxes are usually a property biggest expense and highest percentage of your fixed operating expenses. As an investor you need to make sure that the property taxes are accurate by ascertaining your assessment-to-value ratio is not out of sync to the town’s average.
Steps below will help you verify and take action to appeal your property taxes:
Step A: Request your property assessment card by calling the tax office or you can use online tax services where you can look up property tax description and assessment.
Step B: Once you get your property card, scrutinize the property description by looking up the description codes with the assessor office. Make sure that your property description is accurate as a low paying employee or an intern at the assessment company usually fills out the description and they can make mistakes. If your property is incorrectly described to have extra square footage or stories then you should file an appeal with the assessor immediately.
Step C: Determine your town’s average assessment-to-value ratio and see if your ratio is higher or lower than the towns average. Most towns publish their average assessment-to-value ratio but if yours doesn’t then you can back into the ratio by locating properties like yours in your surrounding neighborhood and checking their assessments. Determine each properties assessment-to-value ratio by dividing the assessment to the respective property value. If your property’s ratio is higher than the average then you would have a case to appeal your taxes.
Step D: If your ratio is higher than the towns or neighborhood average then you should consider pursuing a tax appeal only if it passes the Tax Appeal Payback Rule test.
Tax Appeal Payback Rule
The goal of a value add investor is to only spend money that you know you can get back in under 24 months through expense savings thereby yielding higher net annual cash flow.
Tax Appeal Rule in Action
- Current Taxes: $10,000
- Appealed Taxes: $8,000
- Probability of Success: 80%
- Potential Cost Savings per Year: ($10,000-$8,000)*.80 = $1,600
- Maximum Capital Commitment: No more than $3,000 (two years worth of tax savings would amount to $3,200 so the cost to achieve that savings should be less than the 24 month payback rule).
As long as your property appeal potential passes the payback rule test then you should consider appealing your property taxes. You can pursue your tax appeal either professionally or pro-se.
The best bet is to approach the assessment pro-se and to do so by setting up a meeting with the tax assessor and explaining the reasons and showing the comps associated with why you think the value is too high. Speaking directly with the assessor is the best and cheapest way to go and any savings gained will definitely pass your payback rule test. If you have no success with the tax assessor and you still feel your value is too high then you should consider filing a tax appeal through the help of a professional organization. Just make sure to not agree to spend more than your potential savings gained.
Expense compression value add strategies can be a add value when you cannot increase rental income or ancillary income at a income investment. The goal is to gain additional positive cash flow to help increase the market value of your investment asset. What other expense centers would you want to review to help increase the property net operating income? Leave your answers in the comments below.