Are you running an accidental or unintentional charity at your multifamily investment property? (Hint - you may be and not even know it!)
Many long-time individual multifamily property owners have ever-so-gradually drifted from maximizing their investment returns, as was their original intent in acquiring a multifamily investment property, into accidentally or inadvertently running or overseeing more of a charitable organization (without the tax benefits of one) than an efficient business operation if they have not kept pace with market rents over time. This restricted cash flow and reduced property value scenario can be even further exaggerated when below-market rents are combined with the invisible handcuffs of rent control regulations that strictly limit rent increases for in-place, long term tenants. Once the gap between collected rent and market rent has been created it can be very costly and time consuming to remedy, causing a high percentage of owners to just endure it, or to perpetuate it.
If you have been rewarding tenants with no or low rent increases that have gradually allowed your rents to become significantly below current market rents, while your expenses logically continue to increase - you are likely running a form of unintentional charity that is choking your cash flow and thusly reducing the fundamental income-based investment value of your property!
Some owners become complacently satisfied with the amount of cash flow they are receiving, but are failing to recognize what their below-market rents are doing to the value of their property if they ever decide they do want to sell at some point in time (or possibly need to sell in some cases). Many owners are lulled into a false sense of increasing value when they perceive that their property has appreciated right along with other properties that are similar to theirs in the same area, with equal enjoyment of the “rising tide” of values when they hear what other similar properties have sold for. It is easy to forget that the value of a particular property is most directly tied to the net income that it is producing - rents being collected minus all of the expenses, taxes, etc., as the fundamental basis for an investor to underwrite the current value of a multifamily property.
As an illustrative example; rents averaging 25% below current market rents of $2,500 per month at a ten-unit building would equate to -$25,000 x 25% = -$6,250 per month, or -$75,000 per year in lost potential gross income.
To correlate the net income loss and impact to the value of the property; applying an expense ratio of 35% to the example would equate to -$75,000 x 65% = -$48,750 in unrealized net income or profits that is a direct result of the under market rents. Even more pronounced is the impact on the reduced market value of the building based on the capitalization rate, or Cap rate, that is utilized by most investors (and lenders if an owner has maturing debt to refi, or may be looking to refinance with cash out).
Taking the -$48,750 unrealized profit figure at an applied 5% cap rate reveals that the value of the property is reduced by a whopping -$975,000! (-$48,750 / 5% = -$975,000); nearly $1 Million dollars less than the market value compared to a building with full market rents! Quite eye-opening to realize that an owner is plainly giving up hundreds of thousands of dollars in property value, according to most investor buyers’ valuation criteria, by “charitably gifting” their tenants below market rents, without any economic reward or direct tax benefit for themselves!
This simple table shows the dramatic impact on our hypothetical property’s value as the gap between full market rents increases from 25% to 40% -
What is also abundantly clear is the longer you prolong this condition, the worse it becomes over time. This most often gradually happens to owners out of benevolence for certain tenants (or all tenants), general complacency or laziness, the lack of truly effective property management by the owner or by a professional management firm, or likely some combination of the three.
It is extremely difficult to “catch up” or remedy this situation because the further rents get below market for individual units, the harder it becomes to displace those tenants. For all intents and purposes tenants have only to do nothing to continue in place for as long as they choose under most rent control regulations, and landlords are generally powerless to do anything about it. Most find out the hard way what effect allowing tenants to pay lower than market rents has on their equity in the property, or the negative impact on their profit when it finally does become time to sell or to refinance.
Of course there are other factors that affect value including a property’s condition, how efficiently it is being managed, if there are capital expenditure items needed in the foreseeable future (seismic retrofitting, roof replacement, exterior painting, etc.), property tax increases upon sale, etc., however, the core base metric is the rental income being generated.
Having an objective viewpoint regarding your property’s current value is an important step in understanding how aligned your original investment and returns goals and objectives are relative to the property’s current physical and operating condition – are your goals being met, or are there are alternative measures or strategies you can or should consider?
Complacency can be very costly!
Utilizing Greysteel’s advisory and brokerage experience to assess a property’s current value includes a review of how current rents compare to market rents, as well as reviewing all expenses and assessing if they are in line with guideline efficiencies.
Feel free to call us to discuss your situation and to explore possibilities that may enhance the value of your multifamily investment, help to unlock any dormant or underperforming equity, look at alternative properties that could generate higher returns, or just to have a clear sense of how your property currently stacks up with comparable properties in your neighborhood.