Forced Appreciation: The Holy Grail of Commercial Real Estate Investing

July 9, 2018

 

 

 

One of the most important factors in successful investment in multi-family real estate is to know if a property will appreciate in value. Wise investors understand this is not a guess or a hypothetical, but rather it is a specific investment strategy known as forced appreciation.

 

Property Value Formula

 

If this sounds too good to be true, or if it seems like the Holy Grail of investing, start by considering how property is valued. This is not a subjective property value, but rather a specific formula.

 

The formula is the Net Operating Income (NOI) divided by the Cap Rate (capitalization rate). The NOI includes all the revenue generated by the property less the operating expenses (not including the debt service payments). The Cap Rate is the potential rate of return on the property if it was sold for cash. In general (depending on the market), for new construction high quality properties, cap rates are around 3-5%, and will increase as the quality of the property decreases from the A properties down to the B, C and D properties.

 

To increase the property value, there are two factors in the equation investors in the property can impact. One is to increase the NOI, and the other is to decrease the expenses. In many cases, investors will find they may be able to do both, creating a more favorable NOI which, in turn, boosts the property value significantly.

 

Assessing potential investment properties with an eye to forced appreciation through increasing revenue and decreasing expenses will create increased property value very quickly.

 

Increasing Income

 

The most obvious way to increase revenue in any multifamily property is to increase rent. However, this only works if the units on the property are currently below the market value. A simple way to see how effective this can be is to consider increasing the rent by $10 per month on a 15 unit property. This would result in an NOI of ($10 X 15 units X 12 months) or 1800. Using a Cap Rate of 6% would result in 1800/6% or an increase in property value of $30,000.

 

The $30,000 in this example represents the forced appreciation, which costs the investor nothing out of her or his pocket or investment.

 

Other ways to increase expenses may be to develop cable contracts that provide revenue to the property owners, to consider specific fees for tenants such as pet fees or parking fees or to rent out space in the building, if available, for events, meetings or other types of activities. Ensuring quality marketing to ensure vacancies are filled quickly is another important factor.

 

Decreasing Expenses

 

Most older properties, most specifically those in the B to C property types, have inefficiencies. By simply reducing expenses, it is possible to also boost property value through forced appreciation.

 

Ideas for decreasing expenses can include changing property management companies or renegotiating contracts that are more favorable, abating taxes where possible and reduce the use of utilities in the building to help to reduce costs.

 

The key in forced appreciation is to choose properties where these strategies can be used to increase revenue and cut expenses to provide a higher property value without added out-of-pocket costs. 

 

 

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