At First National Realty Partners, we are value-add investors. This means that we intentionally seek out real estate that we can purchase at or below replacement value and for which we can implement our value-add program.
The goal of the value-add program is to increase the property’s Net Operating Income, which will also improve its market value upon sale. To do this, there are several “levers” that can be pulled, one of which is to invest money – “capital expenditures” – into improving the property so that it is possible to increase the rents. While this concept is easy to understand in theory, there is a nuanced relationship that must be understood between the amount of money that is invested and the resulting rental increases.
In order to understand how these work, it is first necessary to understand how commercial properties are valued.
Commercial Real Estate Valuation Methodology
Many investors are familiar with the idea of reviewing “comparable sales,” which is the primary valuation technique used for residential real estate. With this methodology, a property’s value is derived from the sale of similar properties within the same market. This is not the primary valuation technique for commercial real estate.
Commercial properties are valued based on the amount of Net Operating Income (NOI) that they produce. Net Operating Income – sometimes referred to as cash flow – is calculated as a property’s gross rental income minus its operating expenses.
Gross rental income is derived from the base rent amounts in property leases and any contractual escalations over time. Operating expenses are derived from things like property taxes, maintenance costs, insurance, landscaping, property management, and reserves (NOTE: Depreciation is a common operating expense line item, but it is a non-cash expense so it is not included in the preceding list).
The more Net Operating Income a property produces, the more valuable it is. As such, the goal of any value add program is to increase it.
How Net Operating Income Can Be Increased
At a high level, there are three ways that Net Operating Income can be increased:
- Increase rents and/or implement ancillary fees.
- Decrease the property’s operating expenses through a cost containment program
The focus of this particular article is the potential rental increases that can come from investing a sum of money into a property to improve its physical and/or structural condition. This strategy falls into the category of the first bullet point above.
As value add investors, we look for properties that are in good markets, with good locations, that can benefit from some capital investment. Specifically, we look for grocery store anchored retail shopping centers that could use a makeover. If we are able to purchase one at an attractive price, we can leverage our experience, expertise, and capital to invest in key systems like new HVAC, new roof, repaved parking lot, and enhanced signage.
The theory is that these improvements will attract new tenants who are willing to pay premium rents for a recently renovated space. As these tenants sign new commercial leases, the property’s occupancy improves and so does it’s Net Operating Income.
This strategy naturally begs the question, how does a real estate investor figure out how much to invest in property renovations?
Relationship Between CapEx and Rents
The amount of money to be invested in capital expenditures is constrained by two factors, the cost of the proposed improvements and the rental rate that the market will bear.
Suppose that an investor purchases an office building and, as the new property owner, they make an inventory of the projects they would like to complete. These projects include improved common areas, upgraded exterior, new air handling system, enhanced roof, and new paint. Working with a contractor, they estimate the total price of the improvements to be $1,000,000. It would be unwise to consider this cost figure in isolation. Instead, investors should ask themselves, “if I invest $1,000,000 in capital improvements, how much can I raise the rent to ensure I earn this money back as quickly as possible?”
The point of the upgrades is not to just improve the property for the sake of aesthetics. It is to improve the property with the intent of charging higher rents. The cost of the improvements is an investment and it should be treated as such.
As a general rule of thumb, we aim to earn back our capital investment through rental increases within 24-48 months. Continuing the example above, assume that a property has 75,000 square feet of leasable space. If $1,000,000 is divided by 75,000, the result implies that rents need to increase by $13.33 per square foot total. Taking the midpoint of the above range, $13.33 can be divided by 36 months and the result of $.37 implies that rents need to increase by 37 cents per square foot, per month to justify this level of expense.
Once this figure is determined, the final consideration is to determine whether or not this level of increase is supported by the market. This task is completed by looking at the rental rates for similar properties in the same market. If those rents suggest that this increase is possible, then it can turn out to be a worthwhile investment. If they don’t, an investor could find themselves in a position where they invested a significant amount of money into property improvements, but are unable to increase rents. This is a scenario that investors should look to avoid.
The bottom line takeaway from this article should be this: a value-add strategy can be a lucrative way to acquire a commercial rental property at a good price and increase its value through projects designed to increase its Net Operating Income. The cost of capital improvement projects must be considered carefully and they should only be pursued if the market supports the rental increases needed to earn back the initial investment within 24-48 months.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our real estate investing opportunities, contact us at (800) 605-4966 or email@example.com for more information.