In our last blogcast article, we discussed the importance of cap rates and NOI in determining the risk/reward profile of an investment property. What is counter-intuitive to some, and what we’ll detail in this article, is that an “ugly” property renting well below the market rate will typically provide a less risky opportunity, for us, than a beautiful property renting at the market rate. If that ugly property has neighbors of the same construction type that are renting for much more than it is, this is what we call running room, not risk – and we seek it. Here, let’s talk about how construction execution blends with cap rates and NOI (last blogcast article) and financing (next blogcast article) in our offer-to-operations process.
The Budget
If you remember from the last blogcast article, our offer process evaluates, primarily, (1) what should the property rent for, (2) what will our operating expenses be, and (3) what renovations should we make to bring rents to market – hence, the budget.
Our Tampa Bay construction expertise is one of our critical advantages over other multifamily owners. We utilize our own estimates and subcontractor proposals to understand what renovation projects are going to cost us even before we put an offer together. We develop a budget which prioritizes need projects, which absolutely must happen (such as replacing a bad roof or electric panels), followed by want projects, which we rank in the order of what makes us the most money, and most cheaply.
Next, we ask the bank to give us a loan for about 75% of our purchase price, plus 100% of our construction budget. Whoa! There’s no way a bank would give us that leverage, right? Wrong. Because of our (a) budget & business plan, (b) construction team, and (c) track record, they will give it to us. They’ll even grant us 18-24 months of interest-only payments on our loan while we renovate.. but that’s a blogcast for another day.
The Execution
Once we close on the property, we start certain upgrades ASAP. We’ll likely have some early exterior projects (such as paint, signage, lighting, landscaping, paving, etc.) already on our schedule by the time we close. We’ll likely also take the property over with some vacant units. This is where the magic happens.
Because we buy our properties at a discount compared to our neighbors, we want to figure out how to spend as little as possible to achieve the same (or higher) rents as them. If we come across a vacancy for which the existing unit is in acceptable shape (not new, but not too old), we’ll spend as little as possible (maybe paint, cleaning, and other very minor changes) to get it rent-ready and back on the market as soon as possible – at the same or very similar price that our market-rate neighbors are renting for.
Because our neighbors’ units (if we pick the right neighbors) are probably nicer than our unit that I just described, we’ll likely fall 5-10% below the rents that they’re achieving – this is what we’ll call our base rent. Next, we’ll renovate a unit with the upgrades we believe will produce the highest ROI’s (Returns on Investment); and then advertise that unit to renters at an ambitious rate. If we find that $6,000 worth of upgrades (maybe new cabinets and countertops) get us an extra $250/month in rent, we can quickly calculate that we’ll make our money back within 2 years:
$250/month * 24 months = $6,000
It’s an easy decision to continue implementing this combination of upgrades. But what if those same upgrades only generate us an extra $150? Now, we won’t even make the full $6,000 in 3 years. Is it still worth it?
The answer to this question is exactly why blogcast article 1, Cap Rate & NOI, came before this one. NOI, in this case, is easy – we know that $150/month will create an additional $1,800 ($150/month * 12 months) of annual NOI. While that’s certainly great, here’s the kicker… Properties are valued based on a cap rate. Since we buy our deals in great locations, we’ll be looking to sell them at a low-to-mid 4% cap – so let’s use 4.5%, to be safe. To find out how much value we’ve generated with these upgrades, we divide the extra NOI by the cap rate:
$1,800 NOI ÷ 4.5% cap rate = $40,000
Would you spend $6,000 to gain $40,000 in value, plus an extra $150 of income per month? We would.
If you haven’t figured it out yet, it’s all about the NOI. Over the course of owning a property, we’ll continue to test different strategies (think: ceiling fans, flooring, appliances, etc.) to see what gives us the most bang for our buck. Cheap upgrades that substantially increase rent are no-brainers; but sometimes, the decision is not so obvious. That’s why we run cost-benefit analyses, like the one above, on all of the renovations we consider – before, during, and after we implement them.
But, I have a confession – we buy structurally sound and well-located properties that we want to keep. So, you might ask, what’s all this value creation worth if we’re not selling? Great question, because trust me, we don’t want to wait 5-7 years for a great ROI, either. For the answer, we’ll need to get better acquainted with the cap rate’s step-brother in value creation – DSCR (debt service coverage ratio). To understand how rental increases like the ones described above can create butterfly effects that massively increase our ROI, our next blogcast article will discuss our most important business partner: the bank.
- 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.
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