The best real estate investments experience financial growth by leveraging quality markets with good rent growth to force appreciation.
What is rent growth and why is it important? Rent growth is merely the percentage change in market rents from one year to the next. Rent growth is important, because it is a driver of NOI which determines appreciation.
In an earlier post, I wrote about multisource income (the four ways multifamily investors make money in real estate):
- Cash Flow
- Tax Benefits
- Principal Pay Down
Last week, an article of mine was posted on the popular investing website, White Coat Investor. In response to this post, some questions were raisedabout how multifamily real estate appreciation is created. Therefore, I wanted to write this post to discuss how market rent growth and appreciation are intertwined.
Unlike residential real estate, commercial multifamily real estate is valued based on an income approach. The formula is as follows:
Value = Net Operating Income (NOI) / Cap Rate
Consequently, in stable cap rate markets increasing NOI equates to increased value or appreciation. There are only three ways in general to increase NOI:
- Increase Income
- Decrease Expenses
- Increase Retention
While there are multiple ways to achieve each of the above three, a very obvious way to increase income is to raise rents. This may sound simple, but if you invest in the wrong markets, it will be difficult to impossible to do.
Any given market has a current and a historical annual rent growth. The national long-term average rent growth is 2.1% while current national rent growth hovers around 3.1%. Having said that, all real estate is local and some markets exceed the national averages while others lag behind. Multifamily Executive Magazine reported on some of the best and worst rents growth MSA’s for 2012. I will use two of those markets from this article to demonstrate the relationship between rent growth and appreciation.
To better establish the effects of rent growth on appreciation, let’s do a hypothetical comparison of three different properties with the exact same year one performance in three different markets. For illustrative purposes, we will assume constant rent-growth over a five year period. We will also hold constant each market at a 7% cap rate. We will compare Charlotte, N.C. with a 4.6% 2012 rent growth, with Las Vegas, N.V. (-1.7%) and a hypothetical market with rent growth equal to the long-term national average of 2.1%.
No discussion about rent growth would be complete without discussing expense growth. Remember that NOI is defined as gross operating income (GOI) minus operating expenses. Over time, operating expenses increase due to the effects of inflation. Depending on the market, operating expenses rise between 2% – 2.5% per year. For the purposes of this example, expense growth will be held constant at 2% per year. Each property will start with the same year one financials:
- Gross Operating Income (GOI) = $1,000,000
- Operating Expenses (50% GOI) = $500,000
- Net Operating Income (NOI) = $500,000
- Market Value = $7,142,857
The first graph to the right is of Charlotte, N.C. with a five year rent growth of 4.6% per year. Note how consistent rent growth represented by increasing GOI drives appreciation. In fact, at the end of five years, this property now has a market value of $9,369,625. The next graph is of a market that has rent growth equal to that of the long-term national average which is 2.1%. This graph illustrates the same thing as the first one, just to a lesser extent. After five years, this property now has a market value of $7,792,388. Lastly, is Las Vegas, Nevada. With a negative number, its rents are contracting instead of growing (-1.7%). At the end of five years, this property has lost value making it now worth only $5,607,119.
As I have said over and over again, market selection is critical to make money in real estate and experience financial growth. The best real estate investments will appreciate nicely through rent growth alone if you go to the best markets that are growing in population and thriving with high employment. If you further invest in the better submarkets that have good schools, low crime, and barriers to entry of new supply, you can’t help but make money in multifamily real estate.
P.S. Remember that the best real estate investments utilize consistent rent growth to force appreciation and make money in real estate for long-term financial growth.
Want to learn more?
Download your free copy of Evidence Based Investing and learn why it’s a preferred asset class.