This is a quick and dirty summary of why I love investing in commercial real estate. First time blogger, long time investor! I am an Australian living and investing here in the U.S.!
Let’s start at the beginning: In commercial real estate an assets value is determined using the net operating income (NOI) and CAP rate theory.
Value = NOI / CAP Rate
To make money in real estate you need to increase the NOI of a property, but you might be asking how do I determine the NOI of a property?
NOI = Effective Gross Income (EGI) – operating expenses (OPEX)
To better understand NOI you need to understand effective gross income (EGI):
EGI is simply the potential income that you would receive if your property was full and rented at market rents minus rental losses.
EGI = Gross Potential Income – Rental Losses + Other Income
You might be asking what are rental losses?; well simply put, it’s the amount of money lost as a result of everyday movements of renters moving in and out of the building. Let’s define some of the rental losses, which are set out below:
– Concessions/Promotions/Move In Specials/Referral Credits
– Bad Debt
– Loss to lease
– Model Units/Staff Units
Vacancy, simply put, is the amount of units not rented in a given month as people are always moving in and out of apartments at different times throughout the year. So we apply a % to the vacancy as an estimate of the amount of units which won’t be rented in any given month throughout the year. This number may fluctuate from month to month but you want to average it out. For simplicity let’s say 5% of the units each month will not be rented (that’s 5 units). So if 5 units weren’t rented in a given month that’s a reduction in your gross potential rent: 5 x $600/unit = $3,000 a month or $36,000 a year rental loss from vacancy.
Bad debt is easy; it means the uncollected rent from renters who either skip rent or have to be evicted due to non-payment. Review the rent roll to identify which tenants are behind on rent – they may need to be evicted ASAP.
(TIP: When you are reviewing a potential investment, and you have the rent roll from the owner, look carefully at the move in dates of tenants. Sometimes owners will fill the units with low renters to make the vacancy look better, but typically those tenants only intend to stay short term and might not actually be paying rent; Always ask for all tenancy agreements.)
Concessions/Loss to Lease
Loss to lease and concessions are similar. In general concessions are a financial incentive used to induce more people to rent units in your building. You might offer a reduced rent; say one month free for a signing a 12 month lease.
However, loss to lease is the amount of rent that is below market rent. Example: You might offer tenants a $25/month reduction in rent if they stay for another year. Another good example is when market rents increase during a 12 month period. Say you sign up a tenant at $600/month, which at the time is market rent, however over the course of six months market rents increases to $625/month. Assuming no more increases in market rent you will have $25 a month ‘loss to lease’ for the next 6 months until the end of a tenancy agreement before you can renegotiate a higher price to match the new market rent.
Other sources of income are commonly overlooked by newbie multi-family investors; however maximizing these incomes increases the NOI and the value of the property. The list below outlines some of the common areas of additional revenue streams from a property; not all of these can be applied, it will depend on individual property, and if the tenants will pay for these ‘extras’:
– Application fees: when a tenant first signs a lease
– Late fees on rent (this should always be written into your tenancy agreement; example: tenants will pay $50 penalty if they haven’t paid by the 10th of the month).
– Parking fees
– Pet fees
– Washer/Dryer income: this can be in the form of either having a coin laundry on site, or supplying washers/dryer in the units for an additional monthly charge on top of their rent. Both options work really well if implemented correctly!
– Utility Fees/RUBS: Billing back tenants for usage of utilities (i.e.: water, gas, electricity) if the property isn’t individually metered.
– Month-to-Month rental premium.
– Key fees (fees charged when tenants take the keys at the beginning of the lease).
– Club house rental (this only applies if you have a club house on your property).
Investing in multi-family real estate (commercial real estate) is a business and should be treated as such. To create long term wealth in real estate it is extremely important to understand, and pay attention to, NOI and how to maximize that NOI by:
– Increasing rents
– Creating other sources of income
– And/or reducing the operating expenses of the property
Ideally you want to be implementing all three strategies to maximize the NOI.
Whether you currently own a multi-family, or you are looking at potential investments, a good investor will always look closely at these three keys areas to determine if there is room to move.
Remember, for every dollar ($1) you increase the NOI you increase the value of the property by $10 if it’s in a 10 CAP area. If the property is in a 6 cap area you are increasing the value by $16.67! You are forcing the appreciation of a property,and that’s why I love commercial real estate! Valuing the revenue stream (NOI) generated by a property!
Do all these thing right year in year out, once you own a building; you will experience financial growth that will ultimately lead to long term wealth and finical freedom.