We opened-up dark and cramped kitchens as part of a major upgrade of this 1980’s vintage North Park, San Diego apartment building. This repositioning work was expensive, but generated a substantial rent premium and a significant return on the capital invested. (The original kitchen appears below.) Shallow, numbers-only rent and sales comp surveys can easily miss critical factors driving values such as the extensive modernization within this building.

Are you foolishly buying the future, or deftly profiting from hidden value?

By Robert Vallera CCIM

• The necessity of granular market intelligence
• How rent comps can be deceptive
• The difference between projections and speculation

So Why The Controversy?

With apartment rents experiencing strong growth over the past five years, a sometimes-controversial method is being used to value many of the properties that are currently being sold.

Want to get an earful from an apartment investor? Ask them what they think about purchasing a property based on projected rents. Ask a few different investors and you will probably hear some sharply divergent views. You may hear from investors who have made some exceptional acquisitions by making investment decisions based on projected rents, and from other investors who have lost property in foreclosure by speculating that they could achieve more than the existing contract rents.

Some investors insist that it’s a sure sign that the market cycle is winding down and it’s time to sell when properties are being purchased based on projected rents rather than the actual contract rents. They view this practice as buyers deluding themselves into paying more for property than the cash flow justifies. Using a static analysis, they are correct.

Who Gets What?

When the asking price of an apartment complex is being justified by projected rents, the seller is expecting to receive some or all of the profit from the future rent increase. However, they have left it to the buyer to invest the time and energy, assume the risk, and absorb the costs of bringing the rents to the current market. Who should really be profiting from this work, the seller or the buyer?
Of course, the answer depends upon a whole host of variables, some pertaining to the subject property, such as the amount of time, energy, risk, and costs involved in bringing the rents to market. There are also outside factors such as the number and quality of alternative investment opportunities in the real estate market.

Some of the investors who insist on a static analysis of an apartment investment using only the contract rents will quietly acknowledge that there is upside in the rents, but then insist that every penny of value attributable to this upside accrue to themselves, the purchaser. This is an investment philosophy that should keep you from overpaying for a property. This philosophy might also keep you on the sidelines while market rents surge forward, providing huge returns for investors who are more flexible in their acquisition criteria.

It can be difficult to use a static analysis when acquiring apartments while rents are spiking because apartments are sold in a market, not in a vacuum. When the entire rental market surges forward, all apartment values rise to some extent, even if an owner fails to raise their contract rents to market.

Rent Comps and Inside Information

However, unlike the stock market, the real estate market is assumed to be inefficient. The real key to wise investing during a market surge is to have the best information. Part of the challenge and fun of operating in a real estate market is that it is both legal and ethical to trade on inside information (providing that there is no breach of fiduciary duty by agents and brokers towards their clients.) The term inside information is used here to refer to the most recent market information that might not be part of the consensus known and accepted by the majority of players in the market. The investor who is diligent and who retains the most knowledgeable broker and management team wins.

Investors can make a careful assessment of the strength and depth of the rental market by surveying comparable rents for a property that they are investigating. Scrutinize the caliber of the units that are used for rent comps. How does their age, square footage, condition, amenities and overall ambiance compare to the subject property.

It’s not enough to know that a one-bedroom unit down the street just rented for $1,700. Was it a small, “C” grade unit with older carpeting, with a dozen well qualified applicants standing in line, willing to rent the unit at that price? That’s quite different from a pristine, 750 square foot, condo quality unit that rents for $1,700 after being vacant for a month despite a concerted marketing effort. Was the tenant properly screened and qualified, or has the manager since discovered that the new tenant moved out of their old apartment one step ahead of the marshal, with no intention of ever paying the new landlord more than the first month’s rent plus the security deposit?

Prudent Projections Or Speculation?

It is critical to understand the difference between making an acquisition predicated on an income projection using current market rents compared to speculating upon a future change occurring in the market. If carefully performed rent comps indicate that the contract rents in a building are 10% below the current market, then a conservative projection may factor in a 10% escalation in rents in the subject property over a period of time. This is far less risky than speculating that market rents will increase by 10%.

If you are making a projection of future appreciation, do you expect it to come from the capitalization of increasing rents, a decrease in cap rates, or a combination of the two? Take the time to get out your calculator or use spreadsheet or other financial software to perform some sensitivity analysis. Review your assumptions and figure out how dependent your investment return is upon each of these components.

The Best Information Wins

The memory of the losses and foreclosures suffered by many investors who were overly optimistic during the past two market cycles should alert investors to the risk of looking beyond a property’s proven track record. As with many techniques that are found in the savvy investor’s tool bag, analyzing a property using projected rents can be brilliantly applied to make fabulous profits, or it can be misused with disastrous results.

Remember that the real estate market is assumed to be inefficient. The investors who take the time and energy to assemble the most knowledgeable team and acquire the best information can usually win the game!