Strategy in real estate investment is a matter of mitigating risk and maximizing return. There are a few specific levers that we can influence to maximize our returns.
NOI, CAP Rates, & Property Values.
Let’s start with the very basics. Real estate assets come in all forms. For our purposes, we’re talking about multi-family and commercial buildings and the land they’re built on.
These properties can generate income through rent. They also incur operating expenses such as property taxes, property management costs, maintenance, utilities, insurance, etc.
In basic terms, the difference between rental income and operating expenses is the Net Operating Income or ‘NOI’. If your property generates $200k in revenues annually with operating costs of $120k, then your NOI will be $80k.
Income – Expenses = NOI
Note that operating expenses do NOT include debt-servicing. In this sense, NOI is different than Net Profit. When calculating Net Profit, interest costs are deducted as an expense. When calculating Net Operating Income, they are not.
So. Let’s say you had purchased a property for $1 Million. If you are producing an NOI of $80k, that equates to an annual return of 8% on the full purchase amount. This is your Rate of Capitalization or ‘CAP Rate’.
NOI ÷ Purchase Price = CAP Rate
The CAP rate is the primary metric used to determine the value of commercial properties. It effectively equates to the Return on Investment you would earn if you were to pay cash for the property, with no mortgage financing. Because mortgage terms and interest rates will vary over time, mortgage financing has to be removed from the equation in order to compare one commercial property against another.
At an 8% CAP rate, the example above would likely be a very attractive property. The prevailing CAP rates in Edmonton and Calgary tend to hover around 6-7%. With $80k NOI and a 6.5% CAP, that building would cost closer to $1.2 Million.
NOI ÷ CAP Rate = Property Value
What other factors affect CAP rates? If the property is in excellent condition or has very good tenants, CAP rates can dip below 6%. Also, strong demand for certain types of property such as multi-family buildings can sometimes drive CAP rates as low as 5%. And the biggest factor is location. In highly desirable neighbours or dense urban centres like Vancouver or New York, CAP rates can fall below 4%.
Lower CAP = Higher Value
You can’t do much about CAP rates, though. The prevailing CAP is a measure of market demand for a given property type in a particular region.
But you can influence NOI, which makes things very interesting. If you increase rental income, for example, your NOI will go up. If you decrease your operating expenses, NOI also goes up. These are things we can influence.
Higher NOI = Higher Value
To illustrate, let’s say we have 4,000 ft2 of retail space leasing at $20 per ft2 annually. At a CAP rate of 7%, the property is worth $1.14 Million ($20 x 4000 ft2 ÷ 7% CAP).
We’ve made some improvements on the building and rents are going up slowly in the area. When the lease term comes to an end, the tenant renews at the current market rate of $22 per ft2. This equates to $8k in new revenues per year with minimal additional operating expenses. The property is now worth $1.26 Million.
You can also simply calculate just the incremental value of the rent increase as +$8k NOI ÷ 7% CAP = $114k.
This is how a $2 rental increase can lead to over $100k in new equity in your asset.
Specifically, these are some of the actions that can help with optimizing your NOI:
- Understand market rental rates for similar properties in comparable locations.
- Look for properties with rents under current market value.
- Take good care of your tenants and keep the property in excellent condition.
- Make improvements that will generate additional revenue through higher lease value or greater ft2.
- Raise your tenant profile by marketing actively and screening applicants. Good tenants attract good tenants.
- Manage spending carefully and reduce operating costs.
- Raise rents to market levels as leases come up for renewal.
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