Let’s examine an understood goal of any owner of a commercial multifamily asset: to increase the value of the asset. Before plunging into the “how” of increasing value, let’s be sure to understand a few terms and formulas.
First, a couple of terms:
Let’s pause to see the relationship between the two. A property whose market value is $500,000 and brings in $37,500 for a given year has a cap rate of 7.5%. [$37,500/$500,000 = .075 or 7.5%]
A note of cap rate: The market of investors in a given area determines the cap rate. Like interest rates, cap rates are a reflection of perceived risk. Riskier areas or riskier deals have higher cap rates; this makes sense--the return should be greater to warrant taking greater risk.
Let’s add another term:
The “knobs” which we as property owners have the most control over are the revenues and expenses which determine NOI. Actively managing and improving the financial performance, or NOI of a property, is a means to increasing the value of the investment.
How can we maximize the NOI of properties? More strategically, how can we increase revenues while decreasing expenses?
CONTROLLING WHAT WE CAN CONTROL, PART 1: Increasing Revenues
RENT: The biggest generator of a property’s income is rent. So a natural thought in increasing revenues is simply to bump rent. In setting rent, however, there is a delicate balance of maximizing revenue and minimizing vacancies. When rents are below market rate, money is left on the table, thus reducing NOI. Above market rents, however, can produce the same undesirable reduction in NOI by driving tenants to fairer priced rentals and leaving a trail of vacant apartments in their wake.
In reviewing revenue growth opportunities, we focus on three steps: Market analysis, Setting market rents, and Getting to the revenue goal.
Market Analysis: An increase in rent levels should not be a blindfolded dart throw; instead, it should be the result of careful analysis whose data should drive decision making. A couple of guiding questions can direct the analysis:
In addition to analyzing market demographics, it is necessary to “size up the competition.” What are rent levels of comparable neighboring properties (rent comps) that would serve as alternatives for your tenants? In comparing units, keep in mind that a number of variables can nudge rents up or down: floor plans, interior and exterior finishes, and a host of other factors. Here are a few comparison considerations:
Setting market rents: Evergreen attempts to fall just below competitors’ rent values. Just as a cyclist or racer may fall just behind the leaders to “draft” them, we want to draft the market. After thorough market analysis, we find rent ranges for comparable properties and set our price accordingly. As stated above, consideration of amenities and location which could offer tenants a better living experience will nudge our rents. The total rent you can charge combined with utility reimbursement sets the new revenue goal for the unit.
Getting to the revenue goal: The final step of the process requires a more long-term view, as long as a three year adjustment. Using round numbers for illustrative purposes, if rent of a unit was formerly at $1,500 per month but the market value suggested it could be competitively priced at $2,000 per month, an abrupt jump to that market value may blindside tenants and cause tenant flight and subsequent vacancies. We seek stability with our tenants. Since most residential leases are for one-year terms, we would use each renewal as an opportunity to push rents closer to the market value. Depending on the change from the baseline rent to the market goal, this increase may be phased over as much as a three-year period rather than an immediate increase in rent.
Revenue Management software can effectively keep apartments marketed at the highest rates. Such software systems automate the analysis of market conditions, continually re-pricing units with the goal of minimizing days of vacancy while matching units and lease terms to prospective tenants. This effectively accomplishes the three main areas listed above; however, such a system can be cost-prohibitive and may be harder to implement for smaller properties.
UTILITIES: Another source to raise NOI comes through utilities. An expense of the owner, utility charges can be recouped as a source of cash inflow through Utility Billbacks.
A simple math question: Which is more: $1,300 or ($1,000 + $300). Mathematically, they are the same. However, it often “feels” cheaper for a tenant to pay $1,000 with an additional $300 in utilities than to pay $1,300 for rent and utilities. An itemized rent + utility bill also allows for increases in utility not to be absorbed by the owner. For more on utilities, read our article on “Utility Billback Systems.”
With the goal of increasing NOI, our focus so far has been on increasing revenues. Another variable that we have some control over is decreasing expenses. This should not be confused with “cutting corners.” A saved dollar means little if it comes at the cost of tenant satisfaction; we strive for high quality living conditions that are homes to satisfied tenants. In multifamily buildings, expenses are typically 45%-55% of the revenue range. These expenses do not include interest, federal taxes, depreciation, or amortization. Every dollar reduced in expenses is a dollar increase of the NOI.
Here are some “big ticket items” that we look to evaluate for cost-savings and efficiency:
Real Estate Taxes: This is typically one of the largest expenses and one that varies most by state. A property’s purchase price will provide the best determination for its market value. A recent sale gives the taxing authority new information to re-assess and revise the previous market value that had been used for real estate tax calculations. This reappraisal can cause a significant real estate tax jump depending on prior appraisals of property value. While we account for the new assessment into the terms of the deal, it is always worth the effort to appeal the new assessment in court and apply for relief or a lower assessment. A favorable ruling can yield a large reduction in annual expenses.
Insurance: Another major item worth evaluating--albeit one that is difficult to find relief--is insurance. Rates are often pre-determined by risk and building features like sprinklers, fire alarms, the number of stories, and more. While being cautious of being under-insured, owners can shop annually for the best insurance rates available which could drive down costs.
Repairs and Maintenance: Due diligence in evaluating the potential cost for maintenance and repairs of a building is critical. The age and operational performance of electrical, plumbing, and mechanical systems should be evaluated. A new air conditioning system may be costly in the short-run, but could decrease repair expenses when taking a longer view of the purchase and its maintenance. Evergreen examines the roof, furnace, water heater, electrical panel, and appliances when acquiring a property to evaluate the age and operational performance in deciding a cost-effective course of action with capital expenditures.
Vendor Costs: The tenant-lease agreement should clearly spell out responsibilities for services, most notably lawn care and snow removal. If these services are the responsibility of the owner, negotiating favorable rates while ensuring quality service is the goal, staying at or under budget. The best scenario for raising NOI with respect to such services is for the tenant to be responsible for these services or for payment of the service to be performed.
SUMMARY
Maximizing NOI is an ongoing process and one that demands continual learning. Adjusting the “knobs” to maximize revenue requires finding the sweet spot of profitable and fair rents that guarantee a market of satisfied tenants. The “gauges” of decreasing revenue should not be left unchecked. Careful examination of ways to reduce costs while maintaining a high-quality living experience for tenants is fundamental to bolstering NOI. We at Evergreen enjoy and embrace the dual responsibilty of being operators of our properties, providing quality living experiences for our tenants and being asset managers, improving NOI for our investors.
We would love to talk more about investing in multifamily properties. If you are interested in learning more please contact our office at (724) 900-0009 or e-mail Mark Brooks at mark@evergreen-pgh.com.
