By Joe Pendon

One of the benefits of apartment investing is the the ability to influence the value of the property. That is, the owner of a commercial property can force an increase in value by taking steps to increase the net operating income (NOI). Since the value of a commercial property is based upon the income generated, when you increase the NOI, there is a corresponding increase in value. This phenomenon is known as “forced appreciation”. You can achieve a significant increase in equity through forced appreciation. Let’s look at how this works.

The annual NOI of a property is the gross revenue minus the operating expenses. Revenue comes principally from rent paid by the tenants, but it can also come from things like late fees, onsite laundry facilities and valet trash fees. Expenses include all the items and services needed to operate the asset, like property management, repairs and maintenance, taxes, insurance, and advertising.

The NOI is improved by increasing income or decreasing expenses. A typical value add strategy is to make improvements to the units which allow you to increase the rents. For instance, when you upgrade the countertops and cabinets, it results in a nicer apartment which can achieve higher rents. Improving occupancy and retention also enhances the NOI. On the expense side, professional property management can improve operational efficiency and reduce costs. As stated previously, NOI = gross revenue – total operating expenses.

Introducing the cap rate

The NOI is related to the value of a property based upon something called the capitalization rate, or cap rate. The cap rate is specific to a market and asset type. It represents the return of a property if you paid cash for it without using debt capital. Stated otherwise, the return, or cap rate, is the NOI divided by the value.

Cap rate = NOI ÷ Value

For example, suppose you paid all cash for a $10 million property which has an annual NOI of $600,000. In this example, the cap rate is 6%, or $600,000 divided by $10 million. Conversely, the value of your property can be derived from knowing the market cap rate and annual NOI. The above equation can be rearranged to determine the value:

Value = NOI ÷ cap rate

Value = $600,000 ÷ 6% = $10,000,000

If a property produced $600,000 in NOI per year, and the prevailing cap rate in the market was 6%, then that property would be valued at $10 million.

An Example of Forced Appreciation

Let’s say in the above example you were able to increase the annual NOI to $800,000 over a period of 5 years. You executed a business plan whereby you upgraded the unit interiors and raised the rents. You also improved tenant retention and managed expenses with a top-notch property management company. Assuming the cap rate remained the same, your new value would climb from $10 million to over $13 million.

New Value = NOI ÷ Cap rate = $800,000 ÷ 6% = $13,333,333.

In this example you were able to force over $3 million in equity appreciation through methodical enhancement of the NOI. Forced appreciation is a strategy where the owner exerts control over the value of the property. It is an extremely important tool for wealth creation in multifamily real estate.

One final distinction needs to be made regarding the difference between apartment investments and single-family residential real estate. Valuation in residential real estate is based upon comparative sales, not upon income generated. The value of a house is determined by similar properties in similar condition in a similar location. The price someone is willing to pay for a house is based upon comparable houses. There is only so much improvement that can be done to achieve a higher sales price. In residential real estate the value is largely determined by factors outside of your control. You do not have the ability to force appreciation based on NOI, as you do in multifamily.

Forced appreciation is one of the many advantages of multifamily real estate investing. It is an important equity generation tool. Other advantages of multifamily include stable income, diversification from the stock market, tax advantages, and an evergreen investment. If you have an interest in learning more about this asset class, then please reach out to us at Monolith Property Group.