We recently had several apartment sales where the properties were in similar locations, and had very similar sizes and building types.
Both the buyers and sellers were asking the question – why does one property sell for a much higher price per unit than the other one, when they are both so similar in size and location?
- Most investors are familiar with the 1% rule, which helps with quick decision making. This rule says if the monthly rent is 1% of the unit price, it is a good buy and you should move forward.
These days, finding a property that hits the 1% rule is tough. But, more important, this guide leaves a lot to be desired.
The 1% rule fails to account for the expenses of the property. It also leaves out the improvements that may be needed for the property.
Let’s look at the 2 reasons why investors should trust NOI vs. the 1% rule:
#1. NOI takes into account the expenses
Let’s say property (A) on Happy Days Avenue is a 10 unit building. The average rent is $1,045, and the property sold for $112,000 per unit.
$1,045/ $112,000 is .93% (Almost 1%) Great deal, right?
Then property (B) is on Cemetery Avenue, and is also a 10 unit building that just sold. The average rents are $1,136 and it sold for $144,000 per unit.
$1,136/ $144,000 is .78% (Lower rent ratio)
So, according to this, Property (A) on Happy Days Avenue is the better deal, right? Ah, but that does not take into account the NOI of the property.
- Both Property (A) and Property (B) sold for the same CAP rate, which makes sense because they are very similar in many aspects.
- The reason Property (B) on Cemetery Ave can sell for much more per unit, and was still a great deal, is because the expenses are far lower. Cemetery Ave has all utilities metered separately and billed directly to the tenant.
- Ability to Upgrade: Some improvements made can increase the NOI, like separately metering the utilities like they did in property (B). The resulting increase in the income is a great reason to pay more for a unit.
- Even if you pass on a utility fee or some other additional fee, it is still hard to counteract this with a rising cost that the owner pays for. If the utility cost goes up, but you are charging a flat rate to the tenant, the owner must eat that cost. In contrast, with a separate meter, the tenant eats the cost and the owner enjoys the same rent.
- Tip: Can’t sub-meter your property? Try looking at a RUBS program to bill back utility usage as the next best thing. Some states put limits on RUBS programs, but most allow as long as the Landlord is not making profit on the program, and only charging for the actual utility costs.
#2. NOI accounts for property condition and maintenance
Some investors buy a property, milk it for all the cash flow, and then sell it without having invested any money into capital improvements, updates and non-emergency maintenance.
When it comes time to sell, this shows to the buyer, and they have to add into the price to do these improvements. Items like roof, windows, replacing water heaters, etc do not increase the rent you can charge and thus add to the income value, but these must still be done over time.
- The type of property is important here as well. If the property is an older building that was converted from a large house into a lot of units, likely the units are all unique layouts, and the overall maintenance is trickier.
- A purpose-built apartment building, on the other hand, is usually easier to maintain, as you can predict that the same sink cabinet you order for one will fit all the others, since they are all the same, and you won’t have a problem fitting it up the stairs and into the unit, like you may with the converted unit. So, if you compare Property (A) and Property (B) and one is purpose built and the other is a converted building, the purpose built should sell for more money because of the ease of maintenance.
Maintenance is another reason why Property (B) sold for more than Property (A). If maintenance items have not been addressed, those items will decrease the new owner’s return until they are complete- which leaves the owner with diminished return for a longer time.
It’s a wrap
At the end of the day, buyers are purchasing income! Say it with me, INCOME!
That income over time will always drive the value – whether you measure the value in price per unit, NOI or 1% ratio- the Net Operating Income (NOI) leaves the others in the dust.
- Watch this video for more detail on how this looks in action!
We help many investors focus on the best income stream that meets their investment goals over the long term. If you would like a free opinion of value for your investment property, or are looking to grow your investments, contact us to get started.
