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Turn $1 Into $120 With A Rental Property Investment

One of the things I love most about being in the rental property investment business is the cash flow. In fact, the only thing I like better than the monthly passive income that I receive from my investment properties, is when I sell one of those properties and receive one VERY BIG check!

But while I am waiting patiently for the right time to sell one of my real estate investments and "cash in" so to speak, my focus is on improving the NOI or "net operating income" of the property. Fortunately, by patiently and methodically increasing the NOI of a property, I am at the same time increasing the value of that rental property investment as well.

Sidebar: I have used the terms "cash flow" and "NOI" above. It is important to understand that the two terms do not refer to the same thing. NOI is used for the purpose of valuing income properties and does not take into account debt payments. Cash flow, on the other hand, is what is left over after all the expenses of the property, including capital expenditures and debt payments have been made. 

How Does NOI Affect The Value Of A Rental Property Investment?

Rental properties containing five or more units are typically valued based on the amount of net income that they generate. The more net income a property generates, the higher its value. Makes sense right?

Here's an example that will help illustrate the difference between cash flow and NOI, and how investment property values are affected by both.

I just received the monthly operating statements from the property management company that manages one of my apartment complexes. This particular building typically generates between $3,500 and $4,500 per month in cash flow for me. This month's cash flow? About $3,800. Right on target. (Remember, this is cash flow. In other words, the money left over after regular expenses, mortgage payments and capital expenditures).

Now, there are two things that are happening with this rental property investment in the next few months. First, the existing mortgage is up for renewal. Second, it has been about a year since the last round of rent increases, and it is therefore time to look at raising the rents.

Let's deal with the mortgage refinance/renewal first. The original mortgage was amortized over a 25 year period. I have been paying it down for 10 years now, leaving 15 years of amortization left. But instead of continuing with the same amortization schedule, I could choose to stretch it back out to 40 years. By doing this I will be able to cut my mortgage payments in half, putting an extra $2,000 cash per month in my pocket. (Again, that is after all expenses and debt payments.)

Will this extra $24,000 per year affect the value of the property? No. The amount of the debt payments on a rental property investment do not affect its value. The value is calculated using the NOI, which is calculated before the cost of the debt.

So, if it doesn't increase the value of my real estate investment, why would I choose to "re-amortize" the mortgage? Good question. The obvious answer is of course more money in my pocket each month. But that comes at the expense of paying down the mortgage faster. At the end of the day however, I would rather have that cash in my hands as either a safety net or to reinvest at a superior rate than I could achieve by paying down the mortgage.

Now let's have a look at the affect of a rent increase on the value of the rental property.

How Can A $1 Rent Increase Add $120 In Value To A Rental Property Investment?

On the surface, a $1 per month rent increase doesn't sound like much does it? And from a cash flow point of view you are right, it isn't very much. Who would get excited by an extra $12 of income per year after all. But let's take a closer look.

As I alluded to above, an extra $1 in rent per month translates into $12 per year. All things being equal, that will translate into an extra $12 in net operating income. Now, remember how I said that revenue properties are valued based on their NOI? Assuming a market capitalization rate of 10%, a $12 increase in annual rental income translates into a jump in the value of the property by $120.

Sidebar: A quick way to estimate the value of an income property is to multiply the NOI by 10. Of course this a very rudimentary way to estimate rental property investment values and assumes a market cap rate of 10%, which of course, is not always the case.

A simple $1 increase in monthly rents adds $120 to your "profits".

Let's jump back to my real life example. The particular apartment property that I spoke of has 23 suites. And instead of increasing the rent on one of those suites by $1, a more likely scenario would be to increase the rents on all of the suites by $25 per month. Let's see how that plays out...

23 suites X $25 X 12 months = $6,900 in additional NOI per year

Assuming a 10 cap rate, this would add a total of $69,000 in value to the property. (10 X $6,900 = $69,000)

What's The Bottom Line?

The bottom line is that both cash flow and net operating income are important when it comes to a rental property investment. Remember, cash is king and NOI drives value. Try to structure your financing and management to optimize both.

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