We’ve already discussed the many benefits of investing in apartments (see 5 Reasons Apartments may be the IDEAL Investment). But what are the key value drivers that determine whether a deal will be successful? Well, it turns out that having 25+ years of experience in analyzing stocks help quite a bit when analyzing apartment investments.
Unlike residential homes, apartments are businesses and are valued based on the cash flow they generate. At Cove Investments, we’re working with experienced operators to find opportunities where we can boost that cash flow. That way, we have levers within our control to increase the value of the property, even if the general market is softer when we go to sell.
Early in my investing career, a mentor of mine encouraged me to think about a simplified framework when analyzing opportunities. Of course, you’ll dig into far greater detail in your analysis, but it’s helpful to maintain an overarching sense of context. That way, you focus on what matters and don’t overemphasize what doesn’t.
For apartment opportunities, I’ve shared my framework on the back of a napkin:
The point here is that much of your value creation will be driven by identifying attractive markets (based on medium-term supply and demand trends), finding opportunities to boost rent through renovations, and managing costs by working with a capable property manager. Future posts will explore each of these dynamics in more detail.
Getting your arms around net operating income shouldn’t be too bad – your rent minus your operating costs. The cap rate can be a bit trickier since it’s a more abstract concept. But it’s pretty simple:
Capitalization or Cap Rate = Net Operating Income (NOI) / Property Value
It tells you what similar properties are selling for in any given market.
For example, if a market is “trading at a cap rate of 5%” that means that an apartment generating $500k of net operating income should sell for roughly $10M.
$500k / $10M = .05 = 5%
Using 3rd-grade math, we can rearrange the formula to see that:
Property Value = Net Operating Income / Cap Rate
The cap rate is an essential driver of value. It reflects the market view of different factors including the relative attractiveness of an area, investor demand, and interest rates. The last one matters a lot, and it’s the area where we have the least control. Even if we find the best assets in the best markets, if interest rates rise we’d expect cap rates to rise and property values to fall (all else equal).
Since we can’t confidently predict the future path of interest rates, it’s important to identify opportunities to force appreciation (see more on this here), to be conservative on exit price assumptions (called the reversion cap in our models), and to secure attractive long-term financing.
Even if and when rates begin to rise again, and eventually they will, it’s not all bad for apartment investors.
Keep in mind that inflation is the most common reason for interest rate increases. Fortunately, in inflationary periods, we should expect that incomes and rents should rise too. So you have an inflation hedge that should boost your NOI, partially offsetting the impact from higher cap rates when it comes time to sell.
When we search for investments, we use the framework above to guide our process. We spend a lot of time thinking about the risks we can control (market selection, asset selection, business plan, financing), and those that we cannot. Apartments will not be immune to rising rates. Then again, neither will traditional stocks or bonds. Diversification from the tax-advantaged cash flows from apartments may help mitigate the hit from any potential spike in rates.
Cove Investments partners with experienced operators to provide access to private equity investments in multifamily real estate. If you’d like to learn more, please email us at email@example.com.