Moses Kagan on Real Estate

How do apartment buildings increase in value? And how can you benefit?

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When you put a bunch of money and time into an asset, you want it to increase in value. Obviously.

So you might ask: How does an apartment building increase in value?

Remember: An apartment building investment made correctly should cashflow to you every month, so you make money as you go along. But an increase in value is the icing. Here’s how it can work:

  1. Rents go up as your building or the neighborhood improves. All things being equal, higher rents equal higher profits. So if you pay $1.43MM for $100,000 in profit (a 7 cap) and the profit goes to $120,000, even without any change to the prevailing cap rates, your property should now be worth $120,000 / .07 = $1.71MM.
  2. More people want to own in the neighborhood, driving prices up and (therefore) cap rates down. Say you buy the 7 cap for $1.43MM. Say the rents and, therefore, the profits don’t change. If the prices are bid up such that the prevailing neighborhood cap rate falls from 7 to 6, your property went from being worth $1.43MM to $100,000 / .06 = $1.67MM.
  3. The combo platter. The best outcome is, of course, the rents go up and the cap rates come down. If your profit goes to $120,000 and cap rates fall to 6, the property you bought for $1.43MM is now worth $2.0MM.

There are two ways to take advantage of increases in value:

  1. Sell. Maybe you sell, do a 1031 exchange, take your profits tax free, and invest them in another building in a part of town that’s cheaper but improving. But I don’t recommend it, since you can…
  2. Re-finance. The amount of debt you have on a building is fixed or trending downward, depending upon the type of loan. So any increase in the building’s value accrues to you, the owner, in the form of equity. More equity means you can borrow more. Say you bought that original $1.43MM building with a loan of $1.07MM and a downpayment of $360,000. Now say it’s worth $2.0MM. You can go re-finance for 75% of the value, or $1.5MM. You pay off the original loan of $1.07MM and pocket the remaining $430,000 tax free AND keep your building. Booyah.

 

Legalese: I’m not a lawyer or an accountant and this is not tax advice. 

 


Written by mjkagan

02/23/2012 at 9:22 am

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