This article quantifies the incremental return that can be generated by improving the management of a recently constructed multi-family property. The statistics quoted are not theoretical; they were used to underwrite a recent transaction in Chicago. The results show that a skilled property management team can increase the growth rate of cash flows and make a surprisingly large contribution to projected returns (as expressed by the Internal Rate of Return, or IRR). Therefore, investors could employ skilled property managers to boost returns if they are concerned about the current combination of low capitalization rates (cap rates) and an extended real estate cycle.
Risk and Return in Real Estate Investing
The trade-off between risk and reward is the age-old problem for investors in any asset class. The chart below shows the relationship between risk and return (Internal Rate of Return, or IRR) for commercial real estate investors. Most large real estate investors, in hopes of diversifying the risk in their portfolios, make each type of investment, and then further diversify by geography, quality, or property type.
Beginning on the left, purchasing a stabilized, well-managed property will generate the lowest IRR because the risk is also low. A property is said to be stabilized if the local market has already proven its value because the property manager can charge rents at market rates and vacancy rates are similar to local norms. Investors in this type of property may simply be attempting to increase their portfolios' exposure to real estate
Moving to the right in the chart, IRR rises as real estate investors employ “value-add” strategies to increase the value of property. The value-add strategy highlighted in green requires very little or no additional investment because the increase in property value is achieved by managing the property better (i.e., increasing cash flow) than the previous owner.
The chart shows the direction of the relationship between the risk and return on real estate investments, but it doesn’t show the magnitude of the changes. In reality, properties differ by quality, location, age, and many other characteristics. Therefore, it isn’t possible to precisely estimate IRRs for each type of strategy listed above.
The three value-add strategies in blue require additional investment to improve a property, which increases the potential IRR, but also increases the risk that the improved property will achieve its targeted cash flows after it is re-positioned. On the extreme right, real estate investments literally transform the nature of the existing property, and in success scenarios, create the highest IRR. In these projects, the high potential IRR is the reward for accepting the risks of operational complexity, financing uncertainties, time to completion, and changing market conditions, each of which could impair the IRR actually achieved.
The chart shows the direction of the relationship between the risk and return on real estate investments, but it doesn't show the magnitude of the changes. In reality, properties differ by quality, location, age, and many other characteristics. Therefore, it isn't possible to precisely estimate the IRR for each type of strategy listed above.
The Value of Skilled Property Management
However, it is possible to quantify the incremental return from managing property better than competitors in a specific local market. High-performing property managers achieve higher net operating income (NOI) growth than local norms primarily by
1. Increasing annual rent growth
2. Creating new sources of revenue
3. Reducing vacancies, and
4. Limiting operational costs
Table 1 shows the relationship between the annual growth rate of Net Operating Income (NOI) and estimated IRR for a multi-family property in Chicago.(1)
Chicago’s rent growth has been stable and averaged 2.5% since 2000 (2) and current cap rates are roughly 5.00%(3). Therefore, a stabilized multi-family property with average property management performance would produce an estimated IRR between 10.2% and 12.3% (using the assumptions in Footnote 1).
The value of a skilled property management team becomes clear because the estimated IRR grows roughly 2% for each 1% increase in the NOI growth rate. If a property manager can achieve annual NOI growth of 5%, estimated IRR increases to 16.5%. Outperformance of this magnitude may not be possible for real estate investors who have a high market share, because the higher the market share, the more likely that the investor will achieve the market average. Out-performance may also not be possible in all locations.
However, HP's decade of experience reveals that the Chicago market contains pricing inefficiencies in specific market niches in which the four property management tactics listed above can drive surprising increases in IRR.
At the higher end of annual NOI growth (5%) in Table 1, the estimated IRR of 16.5% approaches hurdle rates for construction projects, even though no construction-realated risk is required. Further, Chicago is the third-largest U.S. metropolitan area, so it is a large and highly liquid market that provides opportunities to acquire under- managed properties, in addition to selling them once cash flows have been improved significantly. (4)
Conclusions
Real estate investors can choose from a variety of projects that contain a range of risks and rewards
One way to increase IRR without increasing the amount of investment is to buy a recently constructed, stabilized, under-manged property and employ skilled property management tactics to significantly increase NOI growth
An Increase of 1% in NOI growth produces an estimated 2% increase in IRR for the project described in the article, which approximates current opportunities in Chicago middle-market apartment sector
By increasing IRR through improved property management, IRRs can begin to reach levels associated with real estate development projects that entail greater operational complexity, time completion, and capital investment.
Questions on this article, and requests for additional research on investing in the Chicago apartment market should be directed to Peter Cook, Director of Capital Markets at HP Ventures Group-Development Services LLC at pcook@hpvgproperties.com
Thanks to our Contributor
Questions on this article, and requests for additional research on the Chicago apartment market should be directed to Peter Cook, Director of Capital Markets at HP Ventures Group-Development Services LLC at pcook@hpvgproperties.com.