Apartments present investors with 4 ways to capture an equity return:
- Equity appreciation
- Operational cash-on-cash returns
- Debt paydowns funded by renters
- An income tax shield provided by tax depreciation
The cash-on-cash return is the annual cash distribution from the investment divided by the equity investment made by each investor.
Cash-on-Cash Return = Annual Cash Distribution / Investment Amount
Example: If a person invested $100,000 and the annual cash distribution received from the investment was $10,000, the cash-on-cash return would be $10,000 / $100,000 or 10%.
Appreciation of value is the largest potential source of gain for equity investors. If you work very long in the multifamily space, you are sure to encounter someone saying that an apartment complex is a “value add” proposition. What does that mean?
What is Value Add?
The sales prices of apartment complexes are determined via competitive bidding with value determined by the bidders’ estimates of future “net operating income” and the market “capitalization rate”. The net operating income, or NOI, is revenue less operating expenses such as maintenance, insurance, utilities, property taxes, payroll and management fees. The capitalization rate has a direct relationship to value because a property’s capitalization rate is calculated by dividing its annual NOI by the potential sales price of the property. Another way to state this formula is to say that the sales price of the property is determined by dividing NOI by the capitalization rate.
Net Operating Income (NOI) = Revenue (ex. rent, pet fees, storage rental, etc.) – Operating Expenses (ex. landscaping, insurance, taxes, utilities, etc.)
Capitalization Rate (Cap Rate) = NOI / Sale Price
Let’s say, for example, that in a sub-market of Dallas-Fort Worth, Texas, properties are trading at a capitalization rate of 6%. Armed with that information we can estimate the “value add” to the equity investment that may be achieved by lowering operating expenses, reducing the vacancy rate, or increasing rents. Let’s say that we can improve one of those operational parameters (or a combination of those factors) by $100,000 per year. Assuming a capitalization rate of 6%, we can increase the value of the property by a huge multiple because the value added is determined by dividing $100,000 by 6%, resulting in an increase in value of $1.67 million.
Multifamily Value Gain Formula
This is the multifamily value gain formula, or value multiple. At a capitalization rate of 6%, the resulting value multiple is 16.67; at a capitalization rate of 7% the value multiple is 14.29; at a capitalization rate of 5%, the value multiple is 20.
This formula or multiple is a major key to understanding why investors benefit from multifamily investments. The value increase does not depend on inflation or on prices at which comparable properties are traded. In the multifamily space value increases can be planned for and managed.
As a real-life example, we recently evaluated an apartment complex that would sell at about $13 million for 136 apartment units, determined using a preliminary capitalization rate of 6.4%. The seller tested upgrading the kitchens in the complex on 6 of those units, spending $4,000 per door. The test showed that rents could be increased by about $150 per month due to this action. If this trend were to hold in upgrading the remaining 130 apartments, for an upgrade cost of $520,000 the annual rent increase would be approximately $234,000. The value of the apartment project could be increased by approximately $3.7 million by making this investment. If the equity raised for the project were 30% of the purchase price, or $3.9 million, the equity investors could capture a return of 94% due to this value add opportunity.
Some ways to increase the equity appreciation of an apartment complex do not require a capital investment. For example, the project sponsor might install yield management software to capture full market rents. The project management might add interesting community activities to reduce vacancy rates. We have a list of over 100 techniques that may be used to improve the operating income of a project.
A Key to Success
One of the most important factors to ensure equity appreciation is to have on site management, supervised by a highly competent property manager. A property manager with extensive “value add” experience can develop a sensible budget for property repairs and upgrades that are important to lowering operating costs and capturing value add returns to investors.