Value Creation

Over the past few months, I spent a fair bit of time refreshing the tenant line-up at one of our properties.

As a result, we now have new tenants in two of the four apartments, as well as a brand-new tenant in the commercial space.

This was a relatively new exercise for us and at some point, I will do a dedicated post on what I’ve learned from the experience (in summary – a lot).

But today, I want to double click on a single aspect of that experience – the implications of a rental increase on the value of the property.

If it seems very real estate specific, you may want to bear with me – because it’s not.

As you will see, there are multiple lessons here for anyone who is trying to build wealth, reach financial independence – and yes, retire early against the backdrop of today’s market environment.

Let’s dive in.

Problem Child

Okay, maybe this is a bit of an exaggeration. However, I was beyond delighted when one of our tenants handed in her sixty-day notice back in July.

You see, I “inherited” this tenant as part of the sale.  She was paying $715 a month for a studio apartment on the top floor.  Similar apartments in the area routinely rent for around $1,000 per month.

Thus, I was delighted to put the apartment back on the market.  Within weeks, we locked in a new tenant for $995.

All in, that’s an extra $280 a month – or $3,360 a year.  Not that much, in absolute terms.

However, you’ve got to keep in mind that I bought this property at a 5.7% cap rate (you can read more about cap rates here)

And so, that extra $3,360 of net operating income works out to about a $59k of increase in the overall value of the property ($3,360 divided by 5.7%).

Now, what property investors usually do after realizing a significant increase in NOI is head straight for the bank and ask for a refinance.  As a matter of fact, that’s exactly what I will do once I bring all other rents in line with market levels.

(The math here is simple: you can either do a tax-free refinance and take all the cash out upfront or pay taxes on the increased income and realize the upside over multiple years.  Mathematically speaking, the former is much more attractive)

Given our bank is happy to finance this property at a 31% LTV, I can release about $41k of capital from the property – all by increasing rent by a couple of hundred bucks a month.

Not too shabby!  But is there more to it than meets the eye?

Better Lucky Than Smart

At this point, the mathematically inclined readers will notice the following:

The only reason a few hundred bucks a month translates into $41k of upside is because of the 5.7% cap rate.

I won’t argue – the table below speaks for itself:

Had the cap rate been 10% instead of 5.7%, the upside would shrink to just $33k.  And if you head into double-digit territory, the numbers get even less exciting.

Of course, that’s not the way things have been going recently.  Interest rates have been on a multi-year secular decline – and cap rates followed.

As a matter of fact, the cap rates in the area have actually compressed even more since we bought the property back in the midst of the pandemic.

Here’s another table showing what the same $3,360 rent increase means at lower cap rates:

Now, I am not here to argue about monetary policy (pointless) or take a view on future cap rates (no one knows).  No point worrying about things you cannot control.

There are, however, two critical lessons here for anyone who wants to be a successful investor in today’s market environment.

Lesson #1: Low Margin For Error

Assume you are looking to buy a property and miscalculate the operating income by $10k.

Perhaps utility bills come in much higher, or property taxes go up, or rents don’t come in where you thought they would.  Speaking from experience, it doesn’t take much.

At a 10% cap rate, you end up overpaying $100k for a property.

Not great, but not a deal-breaker, especially if you pay $1m+ for the property.  You can still make the investment work over a ten-year horizon.

But at a 5% cap rate, you’ve now shelled out $200k more than you should have.  Tough to realize a decent return when you are that much in the hole from day 1.

Believe it or not, but the same applies to your FIRE “number”.

If you believe in a 4% SWR, underestimating your expenses by $10k a year means you’ll retire with $250k less than you should have.

But take that SWR down to 2% and you are now $500k below target.

Before you know it, you are having some uncomfortable conversations around the dinner table and calling up your old boss.

Aspiring retirees, beware.

Lesson #2:  Small Moves, Big Differences

Have you ever wondered why investors get so freaked out about tiny changes in bond yields?  US Treasuries move by a couple of basis points, and the world is suddenly is on fire.

Well, this is why: because in an era of ultra-low yields, those 5bps actually make a world of a difference.

If 10-year Treasuries yield 1% and go up by 5bps, that’s a 5% increase.  It’s an equivalent of an increase from 10% to 10.5% back in the high(er) inflation era.

When rates were on the way down, no one worried.  It was a multi-decade, relatively smooth journey.  On top of it, asset prices were going up – hardly a reason to complain.

One can only hope the journey back up will be just as smooth.  In the meantime, any sudden upward jerks will instantly reprice trillions worth of risk assets – and it won’t be pretty.

The Alternative View

At this point, you may wonder – why own real estate (or anything else) at all?

Do you really want to trade your hard-earned cash for assets – only to see them wiped out by an increase in interest rates?

Well, the problem is that you are already watching your cash being wiped out.  But the inflationary process is so slow and gradual, hardly anyone notices:

It’s like the proverbial frog in the kettle.  And given national debt levels are at record levels, governments worldwide are actually quite incentivized to let inflation loose for a while.

It helps devalue their borrowings (in real terms).  It pushes more and more people into higher tax brackets (funny how they NEVER move in line with inflation).

Most importantly, the vast majority of the population doesn’t even realize what’s going on.

In other words, political bliss all around.

The other argument I will make here is that today’s environment is actually awesome for making money.

You make small improvements to a property you own and realize a ton of value.  Create a side business that generates $10k a year – and watch your FIRE number decline by $250k.

What a time to be alive!

Who knows – maybe the interest rates won’t go back up after all?  tough to bet against a 700-year-old trend:

Source: Visual Capitalist

But the most important point to remember is that if you want to build wealth, there’s simply no alternative to investing.

Yes, you need to focus on cash flow.  Yes, you need a contingency plan to hedge against low market returns in the future.

But no one – I repeat, no one, has EVER gotten wealthy by hoarding cash.  Hate to say it, but you are unlikely to buck that trend.

Thank you for reading – and happy investing!