Everyone is probably familiar with the quote about the three most important parts of real estate being, the location, location, location. But what is it that multi-family real estate investor really buys?
Let’s talk about the income stream in multi-family properties, as it is at the core of how we value potential investments and estimate profits.
Income-producing investment property is fundamentally different from a single-family residence. An example will make this clear. Today, a particular property sold for $250,000. It’s in an owner-occupied neighborhood of single-family homes. It’s a 3 bedroom 2 bath modern house and in good condition. You own the house next door and that’s also a 3 bedroom 2 bath modern house, also in good condition. If you try to sell that house today what do you think you might reasonably expect to receive? About the same amount right? Because everything about your property is comparable to the one that just sold. It’s a market-driven price.
Now let’s compare that to a similar situation with an income producing property. We’re going to take two apartment complexes that are located in a middle class neighborhood. These two properties, similar to the single family homes are physically identical. Built at the same time, designed by the same architect, constructed by the same contractor, both in equally good condition. Everything about them physically is virtually the same but they have one intangible that differentiates the two. The first apartment complex is leased at market rates so the rental rates currently are what the market demands and those leases also call for periodic escalations to reflect current market conditions. Now, the other apartment complex was leased at market rates several years ago but those leases extended for quite a while and don’t have any escalations to increase the rent so we’re currently below market. So the only thing that’s different between these two buildings is the income stream. One property has current market rates and lease clauses that will increase those rates over time. The other apartment has below-market rates and doesn’t have any increases set to occur to reflect market rates. So physically the properties are identical but from the point of view of their income stream, they are different.
Now would you pay the same amount for each of those two properties? Would they be worth to you equally for their investment value? Clearly not. The second building is worth less because its income stream is less robust and will not grow. The income stream is what is driving our estimate of value of these properties and it’s driving what we can anticipate as a return on our capital invested. Does location have nothing to do with the value of property? The aesthetic appeal? These items are still relevant to the extent in which they affect the income stream. Location does matter. If your property is in a very desirable residential location, you are able to: Command higher rent rates, expect lower vacancy and attract higher quality tenants. Location matters in so far as it affects the income stream. The income stream is what drives the value of an income-producing piece of real estate and what drives our expected return on investment.