To understand how we buy and manage properties that generate such outsized returns, you need to understand a pair of terms that you may already be somewhat familiar with – cap rate and NOI. A fundamental step in learning any subject is first understanding the lingo, so let’s dive into these terms and understand why they’re connected, why they’re so important in any real estate investment, and why they’re especially important for RavenReal properties.
Let’s begin by quickly defining a capitalization (cap) rate so that we can use it to understand why Net Operating Income (NOI) is the bread and butter of our business. When we select the right investment properties and get these two tools working together in harmony, we generate tons of profits.
Cap Rate
The cap rate is the rate of return on a real estate investment property based on the income that the property generates. The typical investment property valuation equation is:
cap rate = NOI ÷ purchase price
Your average real estate guru tells you to find your purchase price by calculating NOI (which we’ll define shortly), picking a “good” cap rate, and multiplying the two. Easy! Well, news flash, bucko– we do not get to buy properties by simply choosing our own personally desired cap rate.
Instead, we negotiate with the seller to figure out how much they’d sell their property for, and then use that price to determine what our cap rate will be (1) when we take over the property, before making improvements; and (2) once we’ve improved it. We then compare each of these numbers with (a) the going cap rate in the market, and (b) the available returns in the broader local/regional/national/global investment landscapes to determine if the investment is poor, average, good, or extraordinary. Now, NOI.
NOI
The NOI (again, Net Operating Income) is, simply, the real estate revenue minus the operating expenses for your property. Said another way, it is the total amount of income collected by a property, minus all property expenses not including debt service and non-ordinary expenses (renovations, or ‘cap ex’). You’re probably thinking “Ok, I’ve heard of removing the debt service from this calculation, but what’s this about removing non-ordinary expenses?”. That’s a great question because I admit I’m merging terms here (you may be screaming “No, that’s Net Ordinary Income!”); but stick with me so I can tell you why this is the only NOI that matters for value-add properties like ours.
Let me start by saying that we only buy properties at which the previous owner leaves a massive upside on the table. Part of that upside, always, is physical – and what do I mean by that? Well, to say it plainly, ‘upside on the table’ is code for ‘the owner isn’t making as much money as he could’ – which can be hacked down to – ‘he could charge more for rent. Now, this is slightly simplistic, because there are other types of income (like utility and service reimbursements that you can charge tenants for) that owners typically aren’t collecting, and you can also increase NOI by decreasing expenses – but let’s focus on what’s most important for our properties.
How we Buy:
Once we figure out how much rent we’ll be able to charge at a property, we then ask two critical and distinct questions which will tell us how much we can buy it for:
- How much is it going to cost us to operate the property (what are our ordinary expenses)?
- How much is it going to cost us to bring rents from where they are now to where they should be (what do we need to spend on renovations)?
For example, we may find a property with fifty 2-bedroom units that currently brings in $900/unit/month of total income collected. Looking deeper, we find that expenses will cost $500/unit/month. That means there is $400 of monthly net operating income per unit. To calculate the annual NOI for the whole property:
$400 per unit/month * 50 units * 12 months = $240,000
If the going cap rate in the market is 5%, then theoretically, this buyer and seller should be able to agree on a $4.8 million (MM) purchase price:
$240,000 ÷ 5% = $4,800,000
But I’ll give you the sad truth… unless the seller is motivated for some reason – maybe he has bridge debt coming to term (topic for a future blog), he needs money for something else in his life, he’s scared that a recession is coming, or he’s simply burnt out from owning the property – he’s not going to sell that property for $4.8MM. After all, why would he sell for an even exchange? He wants to beat the market! He might counter our offer and say that he’d sell for $5.3MM (a 4.5% cap rate), and not a penny less. Should we give up? No! There’s still an opportunity to be had, and he’s actually just presented us with some fantastic news.
What if we do some market research and find out this property could rent at $1,300, without spending a dime on upgrades? Now, we’re bringing in $800/unit/month ($1,300 of income minus $500 of expenses), or $480,000 ($800/unit/month * 50 units * 12 months) of NOI. If we buy it for the seller’s counteroffer of $5.3MM, that’s more than a 9% cap rate by the time we’re operating it properly (which should be very quick, since none of the upsides was dependent on physical upgrades):
$480,000 NOI ÷ $5,300,000 price = 9.1% cap rate
The seller might be beating the market on the day of the sale, but we’re beating it by much more once we’re managing it correctly. This is a deal. But wait, there’s more.
What if we find out this property could rent for $1,500 if we were to spend $150,000 on renovations? Now, we’re bringing in $1,000/unit/month, or $600,000 of NOI. If we buy at the $5.3MM purchase price plus $150,000 renovations, our new basis is $5.45MM. With $600,000 of NOI, our stabilized cap rate is now above 11%. This is not just a deal, anymore – it’s a steal!
This is exactly what we look for when searching for properties to buy. We agree with the seller on a price that is enough for him to walk away from the property; but which will also allow us to achieve an extraordinary return – maybe even double the market norm.
Easy, right? Well, not so much. What I just described can be drawn up on the back of a napkin by any Average Joe. There are other ingredients that need to come together to make this a killer recipe. In future blogcast articles, we’ll go over some of the main factors that will make or break a promising value-add deal – namely, construction execution and financing.
- Financial Disclaimer: The financial figures shown above are intended for illustrative purposes only to explain general real estate concepts and are not guaranteed by Raven Real Estate Acquisitions or any of its affiliates. Real estate investing involves many risks, variables, and uncertainties. No representations or warranties are made that any investor will, or is likely to, attain the returns shown above since hypothetical or simulated performance is not an indicator or assurance of future results.
- Investment Advice Disclaimer: This content is for informational purposes only. Raven Real Estate Acquisitions and its affiliates do not provide legal, tax, investment, financial, or other advice. All content presented is information of a general nature and does not address the circumstances of any particular individual or entity.
- Investment Risk Disclaimer: There are risks associated with investing in real estate and securities in general. Investing involves risk of loss including loss of principal. Some high-risk investments which use leverage may accentuate gains and losses. Past investment performance is not a guarantee or predictor of future investment performance.