Last year, we purchased via short-sale a 200 unit apartment rehab project that was just 20% occupied at the time of close. At the very front of the property on a very busy street we have five good-sized retail shops connected to the property. The shops are fully occupied and doing quite well. This is evident with all the car traffic and congestion in the parking lot.
With all the goings-on during the apartment’s extensive rehab, we let the retail portion of the project run on itself and did not pay any attention to it. We figured it’s only 5 shops and we have 6 acres of ugly apartment building to deal with. Makes sense, right?
During due diligence last year, we checked rental rates of all of our apartment’s competition, but did not check our retail rate competition because we figured it’s only 5 shops. Those tenants were paying about $2 per sq. ft. plus we paid their water every month. Now that we’re catching up with the apartment rehabbing of the units, we decided to do a market survey for similar retail shops. What we found out made us hysterically happy! Number one, the retail rents have not been raised since 2002. The going rate is $7 per sq. ft. Secondly, the water should have been sub-metered, but no one thought it was a big deal being only five shops. Boy, were we wrong!
Once we raised the rent rates on the five shops to $6 per sq. ft and properly sub-metered their water (which was a savings of $5,000/month), we saw our net operating income just on those shops go up by $160,000 per year. If we do some quick math here: the area in which the property is located is easily at an 8 cap. Therefore, if we divide our newly added $160,000 net income by our 8 cap, we get an increased property value of $2,000,000!! We just created our own bailout money!! And lot’s of it!!
Here’s the moral of the story: with commercial real estate, EVERY single dollar matters. It’s all about the income. In particular, it’s all about the net operating income, or as it’s sometime referred to as “NOI”. As the NOI goes up, the dollar value of the property goes up. It’s that simple. As the NOI goes down, down goes the property value. It’s that simple. Let me also add that this is assuming that the area’s cap rate remains pretty level and unchanging. Here’s some really easy math just in case you want to test it out your own deals or property:
Since cap rate = NOI divided by sales price, we can flip this math formula around and say that sales price = NOI divided by the cap rate. Let’s substitute “sales price” for “added value”. So, we get “added value” = increase in NOI divided by the cap rate.
3 Ways to create your own bailout monies:
#1: Increase the rent even the smallest amount you can. On an 8 cap property, for every $100 you increase the NOI per year, your property values goes up $1250!! How difficult is that?! Look for ways to increase income by billing back tenants for garbage pick-up, putting in new laundry equipment and charging more,
#2: Reducing expenses will increase your NOI. Look for ways to reduce your operating expenses such as sub-metering any utilities, get property insurance re-quoted, reduce tenant turnover, or bring contracted repairs in-house.
#3: By upgrading the tenant profile and beautifying the property, you will potentially force your lower cap rate lower. A lower cap rate automatically increases your property value assuming your NOI is stable.
What I’m trying to drill home is…real commercial real estate wealth is made in maximizing what’s left after you pay all the operating expenses except the mortgage.