Lowering Expenses Is Not an Efficient Value Add Strategy

[Ben Leybovich]

Say you’ve bought a 24-unit apartment building that generates $24,000/month in revenue ($1,000 per unit). This is a value-add, and you think you can improve the rents from $1,000 to $1,400, which would equal to revenue to $33,600/month.

Currently, the expenses are $10,000/month. This is pretty good at 42% of GOI, but you feel that you can cut expenses to $8,000/month.

You operate in a 5 cap market.

Let us analyze these numbers

Cutting expenses by $2,000/month, which would add $24,000 to the annual NOI, would capitalize to a value of $480,000 at 5 cap. This is great, but...

Question - how much would you need to raise rents to capture the same Delta?

Well, we already know that you'd need to add $2,000 per month ($24,000 per year) to the NOI. Divided among 24 units in your building over the course of a year, you'd have to raise revenue by $84 per unit.

Question - do you think it’s harder to cut expenses by $2,000 per month or to raise rents by $84?

Next, your underwriting tells you that you should be able to raise rents by $400, not $84. Therefore, by focusing on the value add you could create $2.3M of value, not $480,000. And even if your value-add does only 50% of the expected $400, you would still outperform cutting expenses...by a lot.

Question - which should you be focusing on, cutting expenses or value add?

The perspective 

It is extremely difficult to cut expenses without jeopardizing the asset. Naturally we don’t want to overspend unnecessarily. But, it has become fashionable to talk about cutting costs as a means to value-add. Let’s have trash pick-up twice per week instead of three times. Let’s pay less payroll. Let’s use a cheaper landscaping service. Etc.

Of course, we may use energy efficient fixtures or low-flow toilets. Those are easy, and they actually improve the property and make it more attractive to tenants and buyers. But, skimping on personnel or services may look good for a few months but will catch up to us before too long.

Cutting expenses is the cherry on the value-add cake, not the bread and butter of it. The real value is always, always, and always in the revenue.

Hope this helps some of you.