Unlocking the Potential: How Cap Rates Boost Property Value in Multifamily Investing
If you are a real estate investor, you need to understand the impact of cap rates.
Cap rates are the easiest way to increase the value of your property.
But, you can only use them with commercial properties, which include multifamily properties.
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With single family homes and small multifamily homes, up to 4 units, the pricing is determined by comparable market sales.
If you have a dilapidated house and renovate it, you can add substantial value. After that, your property will essentially only appreciate based on the sales prices of similar properties.
That’s not so exciting.
If you increase the rent on a single-family house, your cash flow increases, but the property value does not.
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Now, consider cap rates.
First, what is a cap rate?
Cap rates, short for capitalization rates, involve a bit of math, but it’s easy math.
A cap rate is the annual net operating income (NOI) before debt service (paying your mortgage), divided by the purchase price.
annual NOI, excluding mortgages
Cap rate = ____________________________________
Purchase Price
For example:
-annual income = $100,000
-annual expenses (excluding your mortgage) = $50,000
-purchase price = $1,000,000
Your cap rate is:
$100,000 - $50,000 (NOI)
_____________________________ =5%
$1,000,000 (Purchase Price)
But, didn’t I say you could use the cap rate to increase the property value?
You can…
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First, let’s reverse the math so we can calculate the property’s value.
It’s simply:
NOI
__________ = Purchase Price
Cap Rate
That’s means NOI divided by the cap rate equals the property value.
Instead of calculating the cap rate, as we did previously, we are going to use existing cap rates for your area.
Essentially, the cap rate represents the percentage of return that investors expect, for a particular asset, in a certain neighborhood.
We’ll talk about where to find your neighborhood’s cap rates another time.
For easy math, let’s assume the cap rate is 5% in your city for an apartment building, which conveniently matches the cap rate in our first example. LOL
Let’s also assume your net operating income is $50,000.
Example:
$50,000 (annual NOI)
______________________ = $1,000,000
5% (.05) (Cap Rate)
This matches the purchase price in our original example.
Ok, now for the exciting part!!
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How can you use the cap rate to increase the value of your property?
Simple – increase the NOI.
You can do this by increasing the revenue or decreasing the expense.
If your newly-purchased $1,000,000 building has 10 apartments and you increase the rent by $25 per month, per apartment, what does that do?
$25 times 10 apartments = $250/month
$250/month times 12 months = $3,000/year
That increases your annual NOI in the above example to $53,000.
$53,000 (new NOI)
____________________ = $1,060,000
5% cap rate
That means your $25 monthly rent increase added $60,000 to the value of your building.
If you reduce your insurance cost by $1,000/year, your property is worth another $20,000.
Imagine the value of your personal home increasing by $20,000 just because you reduced your insurance cost.
It won’t.
But, with multifamily, it will.
If you aren’t getting excited yet, let’s keep going.
You add a pet fee - $25/month. Five of your tenants pay the pet fee. That’s another $30,000 in value added.
You switch trash services and reduce your cost from $250/month to $200/month. That’s $600 savings per year, which is another $12,000 in value.
Let’s summarize:
Rent increase ($25/mo) – Added $60,000
Insurance savings – Added $20,000
Pet fee – Added $30,000
Trash savings – Added $12,000
You have spent nothing.
But within a couple of months, you increased your property value from $1,000,000 to $1,122,000.
You added $122,000 to the value of your property for the cost of a couple of phone calls and some paperwork.
Are you getting excited yet?
Cap rates give you an amazing ability to increase your property’s value.
You can add fitness center fees, reserved parking space fees, have cell towers installed on your building, buy supplies in bulk to reduce your maintenance costs.
There are so many things you can do to increase the NOI by a small amount monthly, resulting in significant increases in property values.
This is one of the easiest, and least expensive, ways to increase the value of your property.
Happy Investing!