Let’s talk about forced appreciation in multi-family. Forced appreciation is one of the primary distinctions between investing in a house, a single-family home, and investing in a larger apartment complex.
With a house, we’re relatively at the mercy of the marketplace. What is a home worth? Well, in general, a home is worth what similar homes in a half-mile radius, or a mile radius, or the same neighborhood have sold for in the last six months. You can go in, and you can spend a lot of money renovating a house, upgrading a house, et cetera, but you’re not really, in general, going to push through what the comparable sales in the area support. That’s what the banks go off of. That’s what appraisers go off of. In single-family investments, you’ve really got to buy it right and not exceed a certain amount of budget if you’re going to turn a profit on that project.
However, in multi-family, it’s a little bit of a different animal, and that’s why I wanted to explain it with an example here. I’ve tried to keep it as simple as possible, but we’re going to force appreciation on a multi-family project, meaning that, if you have two apartment complexes very similar across the street from each other, they can have very different valuations based on their income stream. The banks value apartment complexes based on their income stream and their net operating income. This means all the income minus the expenses before the debt service is paid, before the bank gets paid their principal and interest.
In this example, we’ve got a property. Let’s say we take over a property, and the net operating income is $100,000. Maybe the property brings in 200,000, and there’s 50% expenses, so we’ve got a net operating income of $100,000 annually. Now, I’m going to divide it by a cap rate. This is a capitalization rate. I used 10, which is very high, but it makes for easier math. I was actually doing the whiteboard example before with a 7 cap, and it was just more complicated math, so a 10 cap is high, but it makes for easier demonstration of this concept of forced appreciation. Let’s say we take over a property. It’s got a net operating income of $100,000. What we’re going to do is divide that by the cap rate of 10. That’s going to give us a valuation of this property of $1 million speaking in general terms. Obviously, there’s variables, things like that, but we’ve got a valuation of a million, let’s say, at takeover.
Now, let’s say we buy this property, and we’re able to go in and make some improvements. How can we improve net operating income? Well, two ways. We’re going to increase our income, and we’re going to decrease our expenses, or a combination of the two. Let’s say, over a year, we’re able to reduce some unnecessary expenses. Maybe there’s some waste happening, or maybe the property is paying all the bills, and the area will support the residents paying the bills. Maybe we’re adding some paid parking. Maybe we’re getting a slight rent increase after doing some renovations. There’s 100 ways to increase your income and reduce your expenses.
Let’s say, after a year, we’re able to get our net operating income up 10%, so instead of having a net operating income of $100,000, now, after a year, we’re at $110,000. Well, using the same cap rate of 10, which is high, but it makes for easy math, we’re going to have a valuation, if we divide our new net operating income of 110,000 instead of 100, divide that by our 10 cap rate, and we’re going to end up at $1.1 million. Now, what I want to illustrate here, and this is one of the reasons we love investing in multi-family, is that we’ve got, essentially, a $10,000 increase in net operating income, and that’s resulting in $100,000 increase in the valuation of the property, so you have a 10X increase over your net operating income. This is the way that we can force appreciation into a multi-family project that is not necessarily dependent on what’s happening on other properties in the area.
Now, appraisers are going to look at comparable sales. Banks are going to look at that, brokers are going to look at that but, fundamentally, multi-family is different because it’s valued on the income stream. If we can go in and have an effect on that income stream by proactively doing things, making improvements, reducing expenses, tightening operations, all these things that you can do, then you’re going to have a proactive effect on the valuation of the property as well, and so you’re in more control in a multi-family scenario than you are in a single-family investment where you’re really just hoping for good comparable sales in the neighborhood so that you can kind of ride that wave, but you don’t have a lot of control over it. In multi-family, we have more control over the net income stream.
Now, I’ll also note that a 10 cap is high. If this was a 5 cap, you would see a much bigger jump on the valuation here, and you can just do some quick back-of-the-napkin math to get that, but this is what forced appreciation looks like in multi-family, and one of the reasons that we like to be able to control our investment destiny by going in with a sound business plan where we can increase income and reduce expenses at the same time, and we can see big jumps in the valuation.
Now, what do you do after you’ve improved a property? You’ve gone in, you’ve improved operations, increased income, reduced expenses. What do you do at that point? You’re at 18 months in. Well, you’ve got several options. You can do nothing and continue to enjoy the increased cash flow. You can refinance the property. In some cases, let’s say you have raised investor capital, well, maybe you can return 30, 40, 50, 100% of investor capital back, and now you’ve got a machine that’s producing cash that you don’t have any money in. That’s investment nirvana, and that’s when you have a infinite rate of return, right, when you’ve got all your capital back, and it’s still producing cash flow, that is great scenario to be in, or you can sell the property and realize all of your profit on the back end. So there’s you can do nothing, you can refinance it, or you can sell it. Depending on the scenario, any one of those might be a viable option.
That’s what you do. This is what we do with multi-family projects where we force appreciation and we create value by having these incremental gains in net operating income, and that leads to big gains on the valuation on the back end.