Tuesday, December 14, 2010

Increasing Net Operating Income

I've talked a bunch about buying property in previous posts...the logistics of financing, the cap rates on some of my properties, finding properties in different markets.  Once you've bought the property, what do you do then?  Since commercial properties are valued based on the Net Operating Income (NOI), one of the best ways to increase value is to increase NOI.  There are multiple ways to this, and you should do all of them.

The most obvious is to raise the rent! Keeping operating expenses equal, if you raise the rent, you will raise NOI - which affects both cash flow in the short term and property value/sales price in the long term, as property value is a multiple of the NOI.  Some of the things you can do which may allow you to raise the rent:

Rehab the inside of the property.  You have to do some of this when a tenant moves out anyway -- clean or replace carpets, paint the interior.  Other things which I did were to install bathroom fans in all of my units.  When I toured the apartment before buying, I could see and smell the moisture in the units.  By installing bathroom fans, it significantly dried out the places and improved the smell.  One hint if you do this: wire the fan into the light switch so it comes on any time the tenant turns the light on.  This will help keep moisture down. 

Install nice countertops.  Ideally one could install corian, but that could be expensive.  You can get nice (or at least nicer) formica countertops.  These make a difference and will help you land better tenants, which in turn reduces wear and tear and tenant turnover, again increasing NOI. 

Clean up the exterior.  I try to stop by my apartment building at least once a month and the first thing that strikes me is how the place looks.  The last time I went by, I saw some of the shrubs were overgrown, the leaves from the local tree were piling up around the place, and the stairs up to two of the apartments were very dirty, despite the painting they got this summer.  I asked the property manager to have these things cleaned up.  Hopefully, if we treat the property well, the tenants will too. 

In addition to raising rents, the other way to increase NOI is to reduce expenses.  There are several expenses that you can reduce, some of which are easier than others. 

Interest expense

The first two, principal and interest, are not always in your control.  Although with this economy and interest rates low, it is worthwhile to investigate whether a refinance pays for itself.  I recently refinanced from 5.375% 30 year fixed to a 3.875% 5 year arm.  This reduced my payment by about two hundred dollars/month and turned that property from negative to positive cash flow.  The interest savings pays for the closing costs in about two years.  After that, the interest savings is incremental $ in my pocket. 
Reducing your principal expense can be done by moving to an interest-only loan, although these are much harder to get then they were a few years ago, especially for investment properties. 

You should keep an eye on your property tax assessments and bills.  Most counties have a process for appealing the valuation if you feel that the property has been assessed unfairly.  I haven't been successful getting my taxes reduced, but some people make a business out of helping people appeal to the county.

Utilities is an expense you should be pretty aggressive about.  Ideally, you want tenants to pay all of the utilities.  That way it doesn't cost you anything if they take a long shower or leave the lights on, or the door open.  In my building, the tenants pay electricity and there is no gas.  Unfortunately, the water/sewer/garbage is billed as a package by the city, rather than individual units.  I charge the tenants a "utility fee" of $35 per person on top of their base rent, to cover w/s/g. this comes to about $350/month total.  Recently I looked at my w/s/g bill and found that it was $500/month.  I sent the property manager to investigate, and she found that one of the bathtubs had a leaky faucet.  We replaced that and also installed low flow showerheads and aerators on all of the taps (The city provided these for free, and would've given us free toilets too if ours were older).  I am considering "submetering" each apartment for water, which would allow us to bill each tenant separately for this, and align their incentives with mine -- ie keeping water usage low.  Studies have shown that submetering can reduce water usage costs by 35% because the tenants are responsible for their own usage.  I investigated with one company, and they estimate submetering my seven unit building would cost about $5k including installation.  I haven't decided if it's worth it yet.  If I could save $50/month, the ROI would be about 4 years to earn back my money, which seems like a long time.  But I also have to consider how much value this would add to the sales price.  $50x12 = $600.  With a cap rate of 5%, which is not unreasonable in Seattle, the $600 saved per year would turn into $600/.05=$12,000 in additional property value.  With 6% cap rate, it would be about $10k.  This makes it look like a good investment -- if I can really save the $50 or more. 

The garbage bill is another frustration point.  I pay $215/month for a 1.5 cubic yard dumpster with once a week pickup. I pay $0/month for the same size dumpster for recycling.  My tenants fill up the garbage dumpster, but I only saw about four pieces of cardboard in the recycling 75dumpsters.  One of my goals for 2011 is to reduce the garbage produced by half, and move that to recycling, and thus reduce my cost for garbage pickup.  If you want more suggestions on how to reduce your garbage bill, I found a company called Waste Auditing Consultants.  Their business model is to help companies reduce their garbage bill, and then they split the savings with the owner.  The owner is a guy named Trip Topken, and they work with folks with garbage bills from $400/month to $375,000.  Trip gave me some other tips on using a compacting dumpster, talking with the city about alternative carriers and reducing my expense through negotiating my rate with the city.  

If anyone else has suggestions, please feel free to post a comment in response to this post!

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