Rent Increases: A Big Margin of Safety When Purchasing a Commercial Property

One great way for real estate investors to protect themselves after purchasing a commercial property is to be able to increase rents shortly after buying. This accomplishes two things: The debt coverage ratio (Net Operating Income – Debt Service) improves, and the value of the property increases. One rent increase goes a long way in giving an investor a bigger margin of safety in case something goes wrong. Of course, in the real world you can’t just blindly increase rents. If rents are already maxed out, ill-advised rent increases will lead to more vacancy. If it leads to a lot of vacancy, net operating income will fall, leading to a lower debt coverage ratio and a drop in the property’s value.

To give an illustration of how this works, suppose an investor buys a 24 unit apartment complex with average rents of $1000 per month, per unit. Let’s also assume this property has a NOI of $144,000. Apartments in the area are currently trading around an 8% capitalization rate, so the investor decides to purchase the complex for $1,800,000. As an aside, it would be even better if the investor would be able to purchase the complex at a price lower than the current market price. If the investor could purchase the property for 1.6 million at a 9% cap rate, the investor would already have a decent margin of safety (~11%) before any rental increases. In the real world, it is not that easy, as most owners of apartment buildings that large are going to have a pretty good idea what it’s worth. Even if they don’t, they would likely employ a broker to list the property and assuming the broker is competent, the broker would have it listed at the proper price, if not a little higher.

So the investor proceeds with the 1.8 million dollar purchase but during due diligence the investor noticed that comparable apartment buildings were renting for $1100 per month. The former owner had not kept up with current rents and in the process cost himself a lot of money. The new owner decides to immediately increase the rents to $1100 per month. Of course, tenants aren’t happy about this, but if they were to move, they would have to pay $1100 per month for a comparable apartment, so they decide to stay. Perhaps one or two would leave, but if the rent is fair, vacant units will rent out quickly. A word of warning here: If this is done without a lot of thought, or the investor is filled with greed, then vacancies can rise quickly. If all of a sudden after a rent increase, 20-30% of the tenants decide to move out, then it was a poor decision. If that many tenants move out, chances are it’s going to be hard to fill. It’s better to rent 24 units at $1000 per month, ($24,000) versus 20 units at $1100 ($22,000). Bottom line, rental increases should be well though out.

So after a successful raise to $1100 per month, the owner has ~$170,000 in Net Operating Income instead of $144,000. Gross rents would increase from $288,000 to $316,800. Expenses would almost stay the same, property management fees would increase slightly, probably about $3,000. Total expenses would now be around $147,000 leading to the number of $170,000 for NOI. By raising the rents 10%, unlevered income increased from $144,000 to $170,000 or just over 18%. Depending on the interest and terms, if the investor used a loan to purchase the property, his income would jump even more than 18%. If the investor purchased the property with 25% down ($450,000) at 6% with a 20-year amortization period ($116,000 yearly debt service), then income after debt service would jump from $28,000 to $54,000! A 10% increase in rents leads to leveraged income almost doubling!

Of course, increased income is only one component of the increase in rents. Because the NOI increased, the value of the property just increased due to its valuation being derived from NOI. At the same 8% cap rate the property had after purchase, the property is now worth $2,125,000, good for an ~18% increase. Even if the market declines and properties in the area are valued at a 9.5% cap rate, the property is still worth around $1,800,000, which is what the investor paid. That is also a pretty steep drop, almost 16%. After these examples it’s easy to see why investors look for properties with below market rents. The key is purchasing them at a valuation that uses the current rents and not the future potential rents. If the investor decided to purchase this for $2,125,000 thinking he can increase rents to justify the purchase price, then he has no margin of safety at all. Anything bad that happens such as increased vacancy or rents declining, and he is in bad shape. Always buy properties based on how they currently operate.

Rent increases deploy the twin levers of more income generation and increased property value. Used wisely, investors can make a small fortune. Usually, some kind of improvement will need to be made to the property in order to increase rents by a large amount such as 10%. Maybe it needs some new landscaping or paint. Investors want to make sure the improvements are mostly cosmetic (i.e. not expensive). If the improvements are structural or foundational, that is a whole different level of risk. I would much prefer just having to repaint or repair a few things. A little touch up can go a long way and change the perception of the property.

Successful investing is all about purchasing quality assets with a margin of safety. Either purchase properties for less than they are actually worth, or increasing the value through a rent increase. If both can be done, the investment will likely be a home run. Purchasing a property at 10-20% below market price and increasing the rent by 10% plus will make an investor’s cash flow and net worth explode, especially if done with multiple properties over time.

 

One thought on “Rent Increases: A Big Margin of Safety When Purchasing a Commercial Property

Leave a Reply

Your email address will not be published. Required fields are marked *