Investment real estate is valued with the income approach. The income approach simply means what is the Net operating income or “NOI” of the building. The Net Operating Income of the building is simply income minus expenses. NOI does not take into consideration debt service, meaning a loan against the property, so keep that in mind when running your numbers. Put simply, the more your revenue is and the less your expenses are the more valuable your building is. Why are these 8 steps important? Because they are exactly how you accomplish increasing the value of your real estate. Following the 8 steps can take some time. In many cases a year or more. If you are some that has owned the property for a long time, this may be the time to consider passing the extra work along and leaving a little meat on the bone for the next hungry owner. However if you want to maximize the value of your building and are willing to spend some time, effort and money to maximize your profits, this is how it’s done:
Step # 1: Curb appeal. If you overlook curb appeal, you’re missing the point. What if you pulled up to rent or buy a property and your first impression was average at best? What if you pulled up and your first impression was the property is “this owner cares about their property”?. You notice it’s clean, in good repair and well run. Not only does curb appeal attract more tenants, but you can usually get more rent for buildings with good curb appeal. More rent means a higher Net Operating Income, resulting in a higher value of the property. Any prospective buyers for your property would also likely take a lower cap rate (simplest way to think of cap rate is the cash on cash return if you paid all cash for the building) on a building that looks like it is current on maintence and repair. All of this means more equity for the property owner.
If you overlook curb appeal, you’re missing the point
Step # 2: Clean, bright common areas. Whenever you’re looking to significantly increase your rent roll on a property you need to start with the common areas. Why not start in the area that all the tenants, and new prospective tenants use and see? In fact, when we buy a building that we are going to reposition from a C class building to a B class building we always start, along with the curb appeal in step 1, with the common areas. This is because all new prospective tenants will see the common area areas. If these areas don’t look good, like a creepy, dirty or dated laundry room, you may not be able to attract the type of high-quality tenant you want. Once you are done with the common areas you can “go behind closed doors” to update apartments. Even if the building has a lot of work to complete, if you addressed the exterior and the common areas the building looks complete to the community and perspective tenants. I often see landlords improve the interior of the units and save the exterior for last. This makes no sense, don’t do it. Prospective tenants will judge the building from its curb appeal and common areas before they make it into the unit for rent. Actually, if you don’t follow step 1 and step 2, they may not make it into your unit for rent at all!
Step # 3: Rent Roll. This is the quickest and most direct way to increase the value of your investment real estate. It is also the most important because the other steps are designed to ultimately lead to an increased rent roll. For the business types out there, the curb appeal and common areas would be the lead measure and rent roll increase is the lag measure; the ultimate goal. As mentioned in Step 1, it boils down to the NOI. Many properties have very acceptable exterior and common areas with low rent roll. I can hear the conservative owner now” I don’t want to raise the rent because the tenant will move, and I will have to put money into the unit that I don’t want to”. Yes, it is possible the tenant may elect to move if you raise the rent, causing you to need to turn the unit and get it re-rented. Those are the facts of increasing your building to its maximum value. Still not excited about it? There is another strategy for the more conservative landlord. If you’re concerned about the time in effort in turning a unit, you can use a “nuisance raise” strategy. That is where you raise the rent $15 dollars or so at a time. Typically, that level of rent raise is just a “nuisance” to the tenant and not enough to cause them to move. The frequency of these nuisance raises depends on how far below market you are and how concerned you remain about the tenant’s likely hood of staying. And even though $15 doesn’t sound like much, if you have 25 doors that’s $4,500 per year increased NOI! In my experience every 6-12 months is typically appropriate. Your rent roll is your finger on the pulse. Are your rents low? High? Average?
Step # 4: Variable expenses. Variable expenses can be the most dangerous when they catch you off guard. I remember buying a three building, 22-unit portfolio and when I ran the expenses in my original analysis, I had a very different number in that original spread sheet than what I saw in the actual numbers at the end of the first summer on the QuickBooks report! The major difference? My landscape costs. When I reviewed the invoices, I was not only paying to have the grass mowed but they were doing all sorts of sprays and extra services that were costing me money and not necessary. This expense is variable because it can be changed, minimized, or even eliminated. If you wanted to you could mow yourself or maybe you have a zealous tenant, who does it for a very small rent credit. This is just one of many examples. Others may be water features, security systems online, common area cleaners, repair and maintence services, etc. Do you need the level of variable expense you currently have? This is always a great question to ask. If you’re not getting a return on investment with the expense, do you need it? And certainly, if you were getting ready to sell you would want to minimize these expenses w
Variable expenses can be the most dangerous when they catch you off guard here it makes sense.
Step # 5: Fixed expenses. Understanding what all the fixed monthly and annual expenses are critical to understanding your cash flow and NOI, which of course effects the value of your investment real estate. The fixed expenses are typically the easiest to identify but the most difficult to reduce. Have you reviewed them for any potential decrease, substitution, or elimination? Those are your strategic options for fixed expenses. The good news is if you can decrease, substitute or eliminate fixed costs it goes straight to your bottom-line profits and yes of course increases the value of the building! Some examples would be the water bill, garbage bill, property taxes, property insurance, common area utilities and other required expenses to run the property. Real Estate investors can see the need for these types of services so any efficiencies you can build in to reduce these fixed expenses becomes very real in the valuation. So here are some strategies I have used in the past to reduce fixed expenses.
- Customize your sprinkler system to minimize the watering times (location permitting)
- Reduce the size of your onsite garbage container and or add recycling
- Shop different property insurance policies, especially if you have made recent upgrades or have low deductibles. Also, sometimes companies insure the properties for way too much
- Appeal your taxable value to reduce taxes
- Put exterior lights on timers and interior common lights on motion sensors
- Eliminate the on-site manager. We have been able to do this on 40-50 unit buildings and below.
Step Six: Vacancy. This should probably be “Step One” on this list if you have owned your property for some time. Vacancy leads to a slow death. Vacancy is like having products to sell that are in your back warehouse and not out on the shelf for purchase. As you can imagine this kills cash flow and Net Operating Income while at the same time, the vacant unit usually physically deteriorates as well. Unfortunately, the pains of vacancy don’t stop there. Vacancy actually increases your expenses due to the utilities of those vacant units that the tenants would normally pay. Have you ever figured out your cost per day for each of your vacant units? Do the math on this and you will see why vacancy is enemy number 1 and takes the value of your building down! I have heard from many landlords “well we own the building free and clear, so we are not losing any money”. I have to be blunt here….. If that is your perspective, you do not understand real estate investment and may want to consider getting out of it.
Step Seven: Additional income sources. Just as there can be hidden expense pitfalls, there can be hidden treasure with your property as well! What do you think additional income to your building does? That’s right, it raises the value! These hidden treasures are everywhere. Look at your building, the features, the lot and layout. What can you charge for or create and charge for? Here are some examples of creating additional income:
- charging for garages or parking spaces
- storage units on site. You know all those large closets in the common area? Or how about that large garage not being used? Where can you build in storage you can charge for?
- Install laundry machines and vending machines
- WIFI (wireless internet) for the building. If you have video surveillance you are already paying for the internet anyway. An upgrade allows you to offer WIFI for a fee.
- Utility reimbursement. If you are paying the heat or hot water for a building, charge a utility fee
- Pet fees. Not just an upfront deposit AND fee, but a monthly pet charge
And I have read about dozens more, so hopefully you get the point. This is the most common area investment property owners leave money on the table. So, like I said, can you think about additional income sources for your investment property?
Step Eight: Systems and Maintenance. If you don’t keep up with your building maintenance it could cost you a lot more in the long run. To maximize the value of your investment real estate, review how your systems operate. Exterior lights for example, can add up to have a large impact on your bottom-line. If your lights stay on 14 hours of the day compared to 10 hours on a timer, that will affect your annual utility cost, adding expense, therefore decreasing potential value. What about that small drip under the kitchen sink? Not a big deal, right? But we all know what happens if it’s not repaired in a timely manner. A larger repair and maintenance cost, especially if it happens in multiple units, reduces the value to the building with the income approach. What is that repair or upgrade that should be made now to reduce the over cost for the foreseeable future? What systems can you identify on your properties that can be changed or upgraded to reduce your overall monthly expense? Major upgrades that reduce your monthly expenses are called “capital expenditure” and do not count against the value of you building when the NOI is being calculated. If you have a lot of properties, this will take some personal investigation by you but is well worth it if you can influence the Net Operating Income.
Bonus Step! One of the biggest mistakes real estate investors make is they don’t have great bookkeeping. Even if you do all 8 steps well, if you don’t have good bookkeeping not only will it be difficult to manage cash flows and you will let profits leak out the cracks of your real estate boat and take on the waves of expenses that can sink your real estate boat!
One of the biggest mistakes real estate investors make is they don’t have great bookkeeping.
The better your records are, the easier it is to measure your net profit, refinance or sell. A lender is going to need to see the same documents a buyer is when you consider exit strategies or valuations. If they must guess at some of your expenses or are missing some income it could make the difference between you getting the loan or not. If the buyer doesn’t have accurate information upfront, they may ask for a reduction in price if they insert unfavorable data.
If you are passing the real estate to your kids, you may not maximize the adjusted basis they would get there for increasing their tax obligation. Are you reviewing your bookkeeping reports weekly? No? Okay fine, maybe you only have a dozen or two units. But you are at least doing it monthly right? Even if you only have two rental houses you should at least review the financial snapshot monthly. This is the best way to analyze the tips above to improve your cash flow and real estate value.
Key Points:
- The net operating income or “NOI” is how apartment buildings are valued, it’s that simple. The better the net profit of the building is the more it’s work. The simple formula is increasing income and decreasing expenses. Chapter 2 walked you through how to execute this formula.
- The way your building looks, outside to in, will have a direct impact on the income. Simply put, if it is clean, bright, and well taken care of you can get more rent. Therefore I always suggest starting with the curb appeal and common areas.
- How is the current system performing? So often a significant increase to net operating income and value can be made by just being more efficient on what you already have going. Increases in rent roll or charging for storage on the income side. Reduction of expenses like garbage, lazy resident managers and poor utility management on the expense side are excellent places to start.
