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- Jul 24, 2007
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Some of you may have read this article as I have posted it before.
Game Plan - Appreciation
So many people discount appreciation as a viable way to invest. Targeted appreciation can work if you have a game plan. I am not talking about investors that buy non-cashflowing deals in California because property values always go up there.
The following is the basic recipe that I use for apartment investing. Single family homes do not track on the same cycle and do not fit into this model.
Start with the cap rate:
Cap Rate = Net Operating Income (NOI) / Price
(Annual) NOI = Gross Income - Expenses (Not including debt service)
My plan involves finding areas that have been overbuilt with apartments and/or have had some temporary loss of jobs. So basically, these areas have high vacancy rates as a result. If an area is performing well, builders come to build and money pours into the area for development.
If a location has job growth targeted in large amounts and high population growth, this vacancy issue will fix itself.
Owners on the other hand are struggling. Offering rent specials and reduced rents to entice more business. Renters are now moving because the rent specials down the road are worth the extra work. The increased turnover is now leading to higher expenses. The bottom line continues to shrink. In these cases, a vacancy rate of 10% can easily be 18-20% rent loss due to concessions, non-pays, and vacancy.
So, assume that your Gross Scheduled Income is at 290,000 per year and you have 18% rent loss. This would leave you with 52,200 loss and a total Gross of 237,800.
So if your expenses are at 120,000. This would make your NOI at 117,800.
The area is now undesirable due to the rent loss so the cap rate has gone up. Let's assume it is at 8% for example:
price = noi / cap rate
Price = 117,800 / .08 = 1,472,500
Now is the time to buy in this location. Let's say that we buy at full price for the sake of the example. I think many investors may not but the example will still be relevant.
So now we are a couple of years down the road. Vacancy has improved from 10% to 6%. Rent loss has gone from 18% to 7% (the ratio gets smaller as the rental market tightens). To top it all off, rents increased by 3% the first year and 5% the next.
The initial GSI of 290,000 has now gone to 313,635. Rent loss is now at 21,955 and the Gross is now at 291,680.
Taxes, insurance and labor (hourly rate) have gone up but maintenance, turnover, total labor, and marketing have gone down. So we will keep expenses where they were originally at 120,000.
Our new NOI is 171,680
Because the area is now more desirable due to better financials, the cap rate has gone to 7.2%.
What has this done to our value?
Price = 171,680 / .072 = 2,384,444 A gain of 911,944. !!!!
If I put down 294,500 (20% of the price) that would be a gain of over 300%.
What happens when we add in undervalue component where there is mismanagement going on. The initial price may have been more like 1,100,000 and the seller might have even carried back 5 or 10%. Do the math, it is incredible.
Clearly there is a macro economy at play here also. The example only deals with the micro cycles of a given metropolitan area. If you catch the macro cycle on the upswing, the numbers would be better. On the downswing... well, you are hedging your bet by using a process.
I have given a number of presentations showing real life examples. I went into most of them expecting 3-5 year holds but many ended up being 1-2 years because things went well. I have had a number of deals with returns over 100% per year. I have had others with no down that have returned over 1M in 2 years time.
An area is not ripe for these returns just because it has high vacancy. Some areas do not recover well. There has got to be circumstances that cause the vacancy with something on the horizon that is going to remedy the situation. Once the area has improved, the building will pick up again thus renewing the cycle. The prime time to sell is just before this building occurs in most cases.
There are really 3 parts to RE gains: casflow (gotta love it), appreciation, and value added. The value added part comes from mismanaged properties. This is not so visible in a market that is well occupied but it shows up clear as day when there are vacancy issues. The appreciation and value added components each will typically far outweigh the cashflow returns if the process is done correctly. The money from the gains can be rolled into a larger deal where there is more potential for higher cashflow returns and again.... appreciation.
It is a process that I got right out of a book. I thought it sounded too simple.
Game Plan - Appreciation
So many people discount appreciation as a viable way to invest. Targeted appreciation can work if you have a game plan. I am not talking about investors that buy non-cashflowing deals in California because property values always go up there.
The following is the basic recipe that I use for apartment investing. Single family homes do not track on the same cycle and do not fit into this model.
Start with the cap rate:
Cap Rate = Net Operating Income (NOI) / Price
(Annual) NOI = Gross Income - Expenses (Not including debt service)
My plan involves finding areas that have been overbuilt with apartments and/or have had some temporary loss of jobs. So basically, these areas have high vacancy rates as a result. If an area is performing well, builders come to build and money pours into the area for development.
If a location has job growth targeted in large amounts and high population growth, this vacancy issue will fix itself.
Owners on the other hand are struggling. Offering rent specials and reduced rents to entice more business. Renters are now moving because the rent specials down the road are worth the extra work. The increased turnover is now leading to higher expenses. The bottom line continues to shrink. In these cases, a vacancy rate of 10% can easily be 18-20% rent loss due to concessions, non-pays, and vacancy.
So, assume that your Gross Scheduled Income is at 290,000 per year and you have 18% rent loss. This would leave you with 52,200 loss and a total Gross of 237,800.
So if your expenses are at 120,000. This would make your NOI at 117,800.
The area is now undesirable due to the rent loss so the cap rate has gone up. Let's assume it is at 8% for example:
price = noi / cap rate
Price = 117,800 / .08 = 1,472,500
Now is the time to buy in this location. Let's say that we buy at full price for the sake of the example. I think many investors may not but the example will still be relevant.
So now we are a couple of years down the road. Vacancy has improved from 10% to 6%. Rent loss has gone from 18% to 7% (the ratio gets smaller as the rental market tightens). To top it all off, rents increased by 3% the first year and 5% the next.
The initial GSI of 290,000 has now gone to 313,635. Rent loss is now at 21,955 and the Gross is now at 291,680.
Taxes, insurance and labor (hourly rate) have gone up but maintenance, turnover, total labor, and marketing have gone down. So we will keep expenses where they were originally at 120,000.
Our new NOI is 171,680
Because the area is now more desirable due to better financials, the cap rate has gone to 7.2%.
What has this done to our value?
Price = 171,680 / .072 = 2,384,444 A gain of 911,944. !!!!
If I put down 294,500 (20% of the price) that would be a gain of over 300%.
What happens when we add in undervalue component where there is mismanagement going on. The initial price may have been more like 1,100,000 and the seller might have even carried back 5 or 10%. Do the math, it is incredible.
Clearly there is a macro economy at play here also. The example only deals with the micro cycles of a given metropolitan area. If you catch the macro cycle on the upswing, the numbers would be better. On the downswing... well, you are hedging your bet by using a process.
I have given a number of presentations showing real life examples. I went into most of them expecting 3-5 year holds but many ended up being 1-2 years because things went well. I have had a number of deals with returns over 100% per year. I have had others with no down that have returned over 1M in 2 years time.
An area is not ripe for these returns just because it has high vacancy. Some areas do not recover well. There has got to be circumstances that cause the vacancy with something on the horizon that is going to remedy the situation. Once the area has improved, the building will pick up again thus renewing the cycle. The prime time to sell is just before this building occurs in most cases.
There are really 3 parts to RE gains: casflow (gotta love it), appreciation, and value added. The value added part comes from mismanaged properties. This is not so visible in a market that is well occupied but it shows up clear as day when there are vacancy issues. The appreciation and value added components each will typically far outweigh the cashflow returns if the process is done correctly. The money from the gains can be rolled into a larger deal where there is more potential for higher cashflow returns and again.... appreciation.
It is a process that I got right out of a book. I thought it sounded too simple.
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