Warren Buffet is generally regarded as one of the most successful value investors or our time. Mr. Buffet became very wealthy by employing the value investment principles first popularized by Benjamin Graham. While value investing is commonly referred to in the context of securities, the same principles apply equally, if not even better, to multi family real estate investments.
In this first of a series of blogs, we will explore how value investment concepts can be applied to successful apartment investing.
Purchasing at a Discount to Intrinsic Value
One of the most fundamental tenets of value investing is to purchase at a discount to intrinsic value. Purchasing at a discount results in a built in margin of safety against further declines. Seems sensible enough, after all who doesn’t like a bargain? The challenging part is really in calculating the intrinsic value with a reasonable degree of confidence.
In the world of stock investing, intrinsic value is ordinarily calculated through fundamental analysis that projects future income and discounts to a current present value. Determining the future returns of a stock can be difficult even for the most skilled investors. Most well capitalized companies are complex organizations. They may be involved in multiple businesses and diverse markets, each with unique sets of opportunities and risks. As a result, they are a challenge to understand even for company insiders or full time analysts following the company. Smaller companies may be less complex, but information may be also harder to come by with fewer analysts following. Stocks for companies in new and emerging industries are especially challenging as the business models and earnings potential are often unproven or subject to additional technological innovation and disruption.
As a general rule, the less complex the business model and the greater the stability of earnings, the easier it will be to determine intrinsic value.
Intrinsic Value in Apartments
At a high level, the business model for multi family apartment buildings is universally understood. An apartment owner rents apartments to tenants in return for monthly payments. A successful owner keeps the vacancies low, the rents at market rate, and manages expenses. Although the mechanics of achieving these goals can be professionally challenging for the property manager, an investor does not need to be an industry insider to understand the model.
Relative to most publicly traded company stocks, there are relatively few inputs needed to determine the value of an apartment building. The primary method of calculating fair market value is via the following formula:
Net Operating income is simply the annualized amount of rent collected less all operating expenses excluding any debt service. The Cap Rate is a market rate of return based on similar properties in the local market. A knowledgeable commercial broker or investor in the area will know the market cap rates.
By way of example, if the 12 month training NOI is $100,000 and the current Cap Rate for similar parties is 10%, the FMV would be $1,000,000 ($100,000/10%). If the apartment operator is maximizing the NOI of the property and the local market conditions are relatively stable, then the intrinsic value of the property would approximate the FMV. For a stable. well managed property, a discount to the intrinsic value of the property would be a purchase price of less than $1,000,000.
Of course, not all properties are managed to their full potential. Rents may not be at market rate or vacancies and expenses could be high relative to similar well managed properties. Future rent revenue, occupancy and operating expenses are really the only variables needed to estimate future NOI. Not only are there fewer variables to project than for most publicly traded stocks, there is generally much more data available. Rent market rates and occupancy are tracked daily by brokers and data services in all metro markets. Operating expenses for apartment buildings are also supported by ample historical data and generally run around 45% – 55% of gross rent revenue.
Even if the property is currently being managed to its full potential, the future earnings can be impacted by changing market conditions. The future earnings potential will be negatively impacted in local markets with declining fundamentals and conversely will benefit from improving fundamentals. However, once again there are relatively few factors to evaluate. Population and job growth are by the two most important factors. Once again, there is abundant economic data that is readily available for investors in all metro markets.
Buying Apartments at a Discount
As previously discussed, the FMV of a property is derived from the future NOI and the capitalization rate. The capitalization rate is market determined and not subject to influence by the investor or apartment operator. The future NOI on the other hand, can be heavily influenced by the investor or apartment operator. By understanding and making conservative and supportable estimates of future rent revenues, vacancies, and operating expenses, the future value of a property can be easily determined.
Assuming stable capitalization rates, if a buyer can make improvements to improve NOI over time, then they will improve the value of the property. However, unlike in the case of many stock investments, the apartment investor should not be paying full price for the future projected earnings potential. While it is in a seller’s interest to convince the buyer that they should pay up for future increases in rent or lower operating expenses, why should the buyer pay for work for improvements that they themselves will have to make in the future? The seller should not be compensated for the buyer’s future investments in time and resources.
If the apartment investor has sound reason to believe that they can improve NOI and can purchase the property at a value based on current performance of the property, then the property is being purchased at a discount to intrinsic value. Of course, many sellers will not be satisfied to only get what the property is currently worth based on their own efforts to date and will want to be compensated for future potential. When faced with this problem, there really is only one answer for the value investor. Just like Warren Buffet, the investor should be willing to be patient, and continue to look until a true value investment opportunity comes along.