[I don’t have a snappy picture for this post, but please read on]
Why do we invest? Generally, we invest because we feel that our money is better spent purchasing an asset than spent on a night out. We want the money we invest in an asset to be worth more at some point in the future. When we are evaluating different properties to purchase, what is one way to evaluate dissimilar properties? We can use the cap rate.
Cap rate is calculated by dividing the Net Operating Income (NOI) by the cost of the asset (Value). Cap rate = NOI / Value. I won’t go into the specifics here, but this equation is useful to investors. We can rearrange the Cap Rate equation to determine the value of our asset If we solve the equation for Value, we get Value = NOI / Cap Rate. The new equation tells us that there are a two ways to change the value of your asset: 1) An increase in NOI or 2) a decrease in Cap Rate.
For a given property, I generally assume the cap rate remains the same, meaning the only way I can influence the value of an asset is by addressing the NOI. NOI is simple to increase: Increase rent and/or decrease operating expenses.
To illustrate this point, here is a quick example before we jump into the introduction to Energy Efficiency (EE).
I purchased UFUO #2 for $40,000. Half the building was rented and rent was $485/month and included the entire water bill as well as trash (water is separately metered). Trash is $30/month (for both sides) and water runs anywhere from $100 – $140/month. Let’s say it’s an average of $120/month. This was a mismanaged investment. The local trend has been to no longer include water with the rent. In addition, rent had not been increased for 5 years, the rent was about 30% below local market rates.
Calculating NOI ($485 – $120 – $30 = $335/month) = $4,020/year
Our Cap Rate is then: $4,020 / $40,000 = 10.05%
I immediately increased the rent and shifted the water/sewer bill to the tenants. Again, assuming the Cap Rate remains the same, the new value is:
NOI(new) = ($515 – $30 = $485/month) = $5,820/yr
If we now calculate for Value, we get Value = $5,820 / 10.05% = $58,000, an increase of 45%.
We’ve reviewed an extreme example of how your NOI affects the value of your building. Our example above is relatively basic economics (increase rent and decrease operating expenses = higher valuation). I want to introduce you to how energy efficiency improvements to your buildings can lead to increased valuations.
Suppose you own a building and have common spaces in which you pay all the utilities. Next suppose that common space has four light fixtures with four T-12 fluorescent light bulbs (called lamps). Lets further assume those lights are required to be on 24/7. We can easily calculate how much those lights cost to operate: 4 lamps x 4 fixtures x 40 watts per ballast = 640 watts per hour. At 24 hours per day, 365 days per year, at a cost of $0.10/kilowatt (inclusive of all taxes, transmission, etc.), we arrive at a total cost of $560/year to operate those lights.
In order to improve the energy efficiency, the old T12’s can be reduced to newer T8 lamps and ballasts. In addition to reducing the size of the lamp, you are generally able to “delamp”, meaning reduce the total number of lamps present while maintaining the same amount of available light. Newer T8’s consume between 28 and 32 watts per ballast. We’ll use the average 30 watts for our calculations.
If we swap the lamps and improve the ballasts and delamp (two T12’s for one T8), our potential savings would be: 640 watts – (2 lamps x 4 fixtures x 30 watts per ballast) = 400 watts saved per hour. This is a savings of $350 per year. Using the Value equation above, we arrive at an increase in the building’s value of $3,480 because of the reduction in operating expenses. $350/year may not seem like much; at my day job, we have been working with a client and were able to identify $800,000 in energy efficiency measures…imagine what those savings do to the value of your building! (there is approximately 1M square feet under roof)
The last thing to consider when making any improvement to an investment property is the installed cost. Using some rough numbers, the total cost for the install for our example above should be: 4 x $15 (ballast replacements), 8 x $4 (T8 lamps), 4 x $55 (Electrician’s hourly rate) = $312 installed. Obviously, markup, electrician’s rates, taxes, etc. will vary slightly, but it is not a significant cost (it really should only take a qualified electrician 30 minutes per fixture, not one hour above).
Within the first year, not only has the investment paid for itself with the electrical savings, but your investment property is now worth more ($3,480 more in our example). Not all improvements will have a simple payback of less than one year, but most improvements will easily pay for themselves a couple of times over their useful life with the savings from the operating costs.
Check back for additional energy efficiency improvements for your MF investment.