In this episode, Travis Watts explains one fundamental key point about multifamily investing that is often overlooked. Like a business, multifamily apartments are primarily valued at the net operating income (NOI) that they produce. The metrics used to determine the value of a multifamily property are its income generation and what kind of multiple a buyer is willing to pay if they want to purchase that income stream.
On the other hand, single-family homes are primarily valued on comparable sales. Their value depends on the value of similar homes in the neighborhood in which they’re located.
How to Generate a Million Dollars Using a Value-Add Business Strategy
Travis uses a conservative example to illustrate the multifamily advantage. Say you own a 200-unit apartment building and your value-add plan allows you to bump up rents by $25 per month across all units. You’ve increased your NOI at the property level by $5,000 per month. Multiply this number by 12 to get the annual outlook and divide that number by the cap rate, which is 5% in this example.
So the equation looks like this:
NOI ÷ market cap rate = the property’s approximate value
($5,000 x 12)] ÷ 0.05 = $1.2 million
In a 500-unit example, Travis illustrates how bumping rents by $150/month over the course of several years can potentially increase the property’s value by $18 million.
Multifamily vs. Single-Family
Travis breaks down two single-family business strategies: flipping and buy-and-hold. When flipping houses, no matter how much work you put into a home, the primary driver for a home’s value will always be based on comps, or comparable homes in the area. With buy-and-hold deals, you may be able to generate exceptional cash flow through renting the home, but when it comes time to sell, the value will still come back to comparable sales without taking the cash flow you’ve generated into account.
“I just wanted to share this for some food for thought,” Travis says. “If you hadn’t thought through in the past how these value-add strategies come together when it comes to multifamily, and how this income is able to be generated, this episode hopefully helped define that a little better for you.”
Travis Watts: Hello, Best Ever listeners and welcome back to another episode of The Actively Passive Investing Show. I'm your host, Travis watts. I've got a really short but exciting episode for you today. It is titled The Big Multifamily Advantage. I really want to nail down one fundamental key point, that I wouldn't say necessarily people miss, but I would say is of fundamental importance, and perhaps not talked about enough. It's simply this, I'll cut to the chase - multifamily apartments are primarily valued by the net operating income that they produced. That's a lot like a business is valued; whatever company it is, there are not exactly comps out there, comparable sales when it comes to business, so what metric you really look at is how much income does this generate and what kind of multiple am I willing to pay if I want to purchase that income stream.
When it comes to single-family homes, they are primarily valued on comparable sales, because there usually are comps to be had. You're usually talking about a house that's within a neighborhood, and that builder had many floor plans and many models that were very similar, and the same. So you would look at what other three-bedroom two bath 1500 square foot homes selling for, and that becomes what your property is valued on.
Now, I think all of that is pretty well known, we'll say. But what I want to dig into is how to actually generate a million dollars using a value-add business strategy when it comes to multifamily apartments. Let's do some real estate math. You know this isn't my strong point, but I've outlined it here and I've made some notes to keep me on track.
For example purposes, we'll say that we have a 200-unit apartment building. By the way, just for frame of reference, a 200-unit in the syndication space, in the real estate private placement world that I invest personally in, this would be one of the smaller properties that I would consider investing in. I usually don't do anything under 200 units. So for this example, just keep that in mind; I'm giving you a very conservative approach here.
So let's say, just to be true to being conservative, that the group goes in with their value-add plan and they're able to bump the rents just $25 per month, across all 200 units, whether that takes them a month or a year, two years, or three years. If they're able to accomplish that, what they've effectively done is they've increased the net operating income at the property level by $5,000 per month. If you times that by 12 to get the annual outlook, that's $60,000 per year of newly generated income that this asset now produces. And if this property happens to be in a market that is trading around a five cap, or a five capitalization rate... I've made a couple of episodes a few episodes ago, if you want to check them out, on how to analyze a cap rate, what it means and why it's important, so check that out... But for the simplicity of this episode, we're just going to run with this particular market and this particular example has a five cap.
So then here's the simple math to figure out how much value you have actually derived on this property. You would take $60,000, which was the annualized new income created by bumping the rents by $25 per month, and you divide that number, 60,000, by 0.05, or 5%, because that's what the cap rate is for this market. And what you get is $1.2 million. Let that sink in for a minute. The value of multifamily, simply put - yes, there are other variables and factors, but generally speaking, it's net operating income divided by the cap rate in your particular market, equals the approximate purchase price or value of the property.
Let me ask you a question about that... Do you think it is reasonable or achievable in today's world, where we've got inflation running nearly at 8% annualized, that a $25 per month rent bump would be reasonable or achievable? I would argue absolutely. In the market I'm in, I'm seeing way higher rent bumps happening month over month. In the past probably 12 months, I would say more like in the range of $100 to $200 per month, so much larger scale. Again, painting a very conservative example, on a 200-unit is how somebody, including you, as a general partner, could potentially increase the value of a property by over a million dollars.
This is why I am so sold on the value-add strategy; this is why as a limited partner investor I'm always looking at value-add opportunities, rather than purchasing turnkey properties, or core, that are newly built or newly refinished and holding them just for the cash flow coupon. I like to capture some of that equity upside when possible. So if that's not exciting enough for you, then maybe you're not as big of a geek as I am. But let's think about this - I gave you a very conservative example. Let me give you more of a realistic example of a property in my own portfolio, or I should say a handful of properties I've invested in my portfolio.
It's more like, let's take a 500-unit apartment building, let's bump the rents $150 per month over the course of several years. I'm not saying that we take it over and we just increase rents by $150 a month; you're going to lose a lot of residents if you do that. This is just happening over the course of time. So you fast-forward three, four, or five years down the road; let's say the group was able to achieve that. So what they just did effectively is they increased the net operating income on the property by $75,000 per month; you times that by 12, that's nearly a million dollars; it's $900,000 of newly created income.
Again, if we take the same market we used in the previous example at a five cap, then you just simply do the math. You take $900,000, divided by 0.05 or 5%, equals --drumroll-- $18 million is what you just increase the property by; approximate numbers, of course. There are lots of other variables, but approximately that.
Break: [00:09:18] - [00:11:05]
Travis Watts: All of this is why it's so important to understand the primary difference between multifamily and single-family. When I first discovered how this worked, and I first saw this happen with real people that were really investing, I just simply couldn't go back. I simply couldn't keep doing what I was doing, which is single-family homes. So let's talk about that just for a minute, and compare it to single-family homes. There are generally two strategies - I know there are a lot more, but generally, there are two strategies people do with single-family homes.
When it comes to investing, you're either going to try to renovate and flip a property, buy low sell high, or you're going to buy and rent it out in some capacity. Let's start with the first example of a flip. To use some simple math, let's say you're doing kind of a more luxury flip. You buy this home for a million dollars, this single-family house, and you put $500,000 into it, you make it beautiful. The goal is you're going to try to sell it for $2 million; that gives you kind of the margin, less the fees, the broker fees, taxes, and all that kind of stuff. That's the goal. But here's the deal - if while you're in the process of doing that kind of renovation, your neighbor or somebody close by with the same comps of home, they have a foreclosure or a short sale, or they just decide to sell low for any other reason - well, the primary driver of the value of your home is going to be based off the comps. Of course, they're going to consider renovations and things like that, and buyers will as well. But it's going to be really hard for an appraiser to come in and say, "Okay, you're asking $2 million for this home, and you have a buyer lined up that's getting a mortgage. But the most two recent sales around here were $900,000 on other homes. I just can't justify saying yours is $2 million when the most recent comps were $900,000." So it didn't really matter that you put all your effort and energy in there and saw the vision, because what was really controlling the value was the comparable sales around you.
Now let's take a second example, the buy-and-hold example. Let's say you bought that million-dollar home, you put a resident in there, a tenant, and they paid above-market rent. Off the top of my head, I don't even know what the numbers would be, but let's say they're paying $7000 per month to rent it from you and your cost is $4,500 for your mortgage or something like that. So you're making exceptional cash flow, you've got a great renter, they've got the highest credit score ever they make bookoos of money, it's awesome. They pay on time every single month, they pay right on the first, so the next year you raise the rent, now it's $8,000 per month. So now you're getting well above-market rents, with an awesome tenant and you're a great landlord, and you've done all the right things. But when it comes time to sell, if you choose to do that, does it really matter? The answer is no. You've increased the value of that property at $0. Even though you were able to bump the rents in the double digits, going from $7,000 to $8,000 - that's an awesome rent bump, but it doesn't matter, because most often who's buying a single-family home is an owner-occupied individual. This is someone looking at your home and saying, "I don't care that you have a renter in there, I don't care what kind of rent you're getting, because I'm buying this property because I want to live in it. This is where my family is going to move into." So it really didn't matter, even though you did all the right things. So again, it comes back to the comparable sales.
So you're still doing a value-add kind of strategy, you're buying this home, maybe fixing it up a little, putting a resident in, and bumping the rents... But ultimately, you're not able to capture, in most cases, the same kinds of return on investment that you may have in multifamily apartments.
So you guys, I made this episode just out of food for thought. I'm not putting down single-family investing. I know there are a lot of folks listening to this episode and in the community that flip homes and do vacation rentals. Look, I did this stuff for six and a half years, single-family; I did it all myself and... I wasn't very good at it, but I did it and I tried.
My point is that I'm just sharing with you my journey of where I came from. I tried these other strategies at the point that I got educated and I started realizing risk points, sustainability, and other factors of scalability. I just decided that for me personally, multifamily apartments was kind of the next step and the move up, so to speak.
So again, it was at the moment that I discovered the power of multifamily apartment investing that I really couldn't look back, I really couldn't keep going on the single-family route that I was on. But you do you, like I always say. It's not that you can't make money doing other strategies, it's not that you're not crushing it or getting great cash flow off your single-family homes. Everybody's different. I just want to share this for some food for thought.
If you haven't thought through in the past how these value-add strategies really come together when it comes to multifamily and how this income is able to be generated - well, this episode hopefully helped define that a little better for you.
Thank you again so much for tuning in to another episode of The Actively Passive Investing Show. I'm your host, Travis watts. Don't forget to like, subscribe, and leave a comment. Let's connect on social media. I look forward to helping you or anybody else that might find some value in what we talked about here on the show. Have a Best Ever week. See you on the next episode.
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