When conducting a BRRRR of a property that a bank only allows a commercial mortgage on (4+ units), the ways to add value are much more straightforward than a smaller multi-family. I want to use this post to give a little insight on why I love commercial investing.
How The Property Value is Determined
The beauty of commercial real estate is that it largely only comes down to 2 numbers: Net Operating Income (NOI) and Cap Rate. So much so that the formula to determine the value of a commercial property is Net Operating Income / Cap Rate = Property Value. So what are these?
Net Operating Income is simply your income left over after all business expenses, not including principal, interest, or any reserves (since those aren't expenses yet).
Cap Rate is essentially the value given to a property reflecting the risk involved in the investment, which is expressed as a percentage usually between 4%-12%.
Okay so what does that mean and how does that reflect the property value? Let's look at a coffee shop example. Say you find two potential investments: a mom-and-pop coffee shop or Starbucks that both generate $100k in Net Operating Income per year. Which would you be willing to pay more for? Obviously you would want the Starbucks because they have the security of being a global brand with tried and true systems and processes that make it a much less risky investment than a mom-and-pop shop. In this instance, an appraiser may assess the Cap Rate of the Starbucks to be 5%, while the mom-and-pop shop is assessed to have a 10% Cap Rate. This means that the same investor (in theory) would be willing to pay $2 million for the Starbucks or $1 million for the mom-and-pop shop that both make $100k in NOI per year ($100,000 / 5% = $2 million; $100,000 / 10% = $1 million).
How Can I Add Value Then?
Because there are only two variables to worry about, you can focus your attack. You can increase your NOI by either increasing revenue or lower expenses. Making capital upgrades, such as painting, cabinetry, flooring, or countertops allow you to charge higher monthly rent because the unit looks nicer and is "newer" while also not be immediately expensed as they are depreciated items (talk to your CPA or hire a good one). If you are able to find an investment whose previous owners were renting below market rents, it's an easy solution to raise rents to market.
How Can I Affect Cap Rate?
Some people will tell you it's not possible. From my personal experience, I will tell you it 100% is possible because I did it. Over the course of 1 year, I was able to lower my cap rate by 1%, which can make a monumental difference in value. The key is thinking about it from a bank's perspective. As a Cap Rate is indicative of the risk involved in owning the property, you want to focus on doing things that make your investment less risky if a bank ever had to take over.
You can make your investment less risky by doing some of the following things:
- Convert all month-to-month tenants to annual leases
- Implement strict minimum rental criteria
- Add security cameras
- Make large capital and preventative improvements (fix drainage issues, install water pressure regulators, replace old HVACs...you get the picture)
- Essentially, prove with action that you are caring for the property on a long-term basis
The only way this is effective is if you document everything you are doing as well. And don't be afraid to mention to the appraiser where your cap rate was previously and where you feel it should be (within reason). Write it all down, print it out, and hand it to them. If you have a strong reason to believe you can command a lower Cap Rate, go for it. The worst they can do is disagree.
I hope this was helpful, even for just one person. There was lots of mystery when I got involved and I hope this can clear things up for you. If this was hard to understand or I can help you with other advice, please feel free to connect with me a message me. Happy BRRRRing!
