Last week, I went over Key #3, so this week let’s learn Key #4 and #5 shall we? Although there are many moving parts to apartment rehabbing, I have found through the years, common things that lead to great success. I follow these and implement them wherever I go. Here they are.
Five keys to successful apartment property rehabbing:
- Key #1: Make physical and cosmetic improvements to the property
- Key #2: You are in the construction business, so be good at it
- Key #3: Be in a strong location and know your market very, very well
- Key #4: Focus on the net operating income and know your cash position at all times
- Key #5: Have more than one razor-sharp exit strategy and be flexible to market changes
These 5 keys are simple to understand yet are very expansive in content. Read on.
Key #4: Focus on the net operating income (NOI) and know your cash position at all times
Remember that income-producing real estate is valued more on its income production than anything else. The more income you generate, the more it is worth. It’s that simple. Here’s a quick analysis:
Apartment building A: NOI generates 75,000 per year. At an 8% cap, it is worth $937,500
Apartment building B: NOI generates $100,000 per year. At an 8% cap, it is worth $1,250,000
Assuming that the properties are comparable, that’s a $312,500 or 25% difference in value just because of the higher NOI.
The Net Operating Income (NOI):
- In a nutshell, you can increase your NOI by either increasing your gross income collections or by reducing operating expenses, or by both.
- The easiest way to increase the NOI is to increase the rent or lease rates when the leases expire. Stay on top of the market and increase the rent whenever you can. If your occupancy is constantly at 100%, it means that your rents are too low.
- After a rehab, you should expect to increase the rents, even on the long-term loyal tenants. They will expect it too.
Expect a few tenants to move out as this gives you the opportunity to replace them with higher-quality, higher-paying tenants.
- Another way to increase NOI is by reducing operating expenses by bidding out insurance, keeping closer tabs on repairs and maintenance, and passing on utilities to the tenants. Convert owner-paid heat and electric to tenant-paid utilities.
Cash Positioning and Rehab Budgeting
Knowing your cash position every step of the way is a crucial part of every successful rehabber’s way of life.
Establish both a rehab budget and property operating budget. Due to the distressed nature of the property and its lack of historical financial data, your budgets will be not as accurate as if you were purchasing a stabilized property.
• Anticipate and budget the income to drop initially as tenants will either move out from all the ruckus around the property or will have to displaced during the rehab.
• The rehab budget will come from the bids you receive from contractors.
• Have a “contingency fund” in your rehab budget because there will be cost-overruns and things you missed that need to be done. I tack on an additional 15% to the budget for this.
• Most rehabs operate under a drop dead deadline, meaning that at a certain point, loan payments or investor payments will have to be made. Design your rehab budget realistically with plenty of room for delays. Delays will occur. As a rule of thumb, I add a 25% cushion of additional time to meet such deadlines.
Key #5: Have more than one razor-sharp exit strategy and be flexible to market changes
It’s important to have an exit strategy thought of before you make an offer on the rehab project, during your ownership, and after you sell.
Reasons before: it’s smart to have an exit strategy before you purchase your rehab because you need to prove to yourself that how you plan taking your profits is realistic.
Reasons during: life happens – the market could change, the economy could change, or your personal situation could change. Being flexible with your exit strategies will give you peace of mind during one of these instances.
Reasons after: this is probably the most important exit strategy. If and when you sell your completed rehab, it is possible that Uncle Sam profits more than you do. Plan smartly with a good tax strategy for when the sale takes place.
Consider doing a 1031-exchange.
4 Typical Exit Strategies:
#1: After rehab: Hold onto the property for cash flow and equity build up.
#2: After rehab: Position the property to sell for huge profit
#3: After rehab: Refinance, pull cash out and hold
#4: After rehab: Sell property and 1031-exchange into a larger property