Summary: In previous posts, we discussed the importance of sticking to your criteria when screening (1% rule) and purchasing investment properties (cash-on-cash return). In contrast, this post covers the gray zone – what to do when a property is close to, but does not quite meet your criteria? And how do you spot hidden value to make a not-quite-perfect deal work for you?
[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
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Kenji and I like to think that we stick to our criteria when it comes to real estate investing. We use the 1% rule as a quick screen to identify properties that warrant a deeper look. Then, we run analyses on these properties to see if they meet our goal of greater than 10% cash-on-cash before making an offer. We keep each other honest when one of us starts to compromise on our criteria. This happens more than you might think! Also, we follow (and repeat often) the mantra: “never become emotionally attached to a property.”
The reality–Kenji and I have often let properties that don’t meet the 1% rule get past our initial screen. We have purchased properties that do not immediately meet our current goals for cash-on-cash return. In fact, upon reflection, I would say that most of our properties fall into this category.
So how do we justify buying properties when they don’t initially meet our criteria?
The key is: we get these properties to meet our criteria by finding ways to increase rental income with hidden value.
What is Hidden Value?
In this article, hidden value is defined as the features of the property that are not being fully utilized to generate a higher financial return.
Just like there is an art to medicine, there is also an “art” to recognizing how a property, which doesn’t quite meet your cash-on-cash criteria, can be made into a good deal. There are two main ways to find hidden value: 1) identify ways to increase rental income or 2) identify ways to cut costs.
There are countless ways to increase revenue and reduce expenses. Your options for hidden value are only limited by your creativity. Below we list some of the most common sources of hidden value.
Find Units That Are Renting Below Market-Rate
One of the easiest ways to increase rental income with hidden value is to determine if a property’s current rents are maximized to today’s market value.
For a multifamily unit, one simplistic approach we use is to compare the rents of identical units in the property and to see if there are any differences. For example, if a four-plex currently has identical units renting in a range from $700-$800, you can reasonably assume that all units should be able to rent for at least $800 (and maybe higher if this is below market value).
The caveat to this approach is that you might overestimate the rents if one unit has been recently renovated and the others have not. Therefore, the property may require additional capital to get the rents to the same level as the highest renting unit.
Find Hidden Value Through Property Managers
A more sophisticated way of determining market rents is to leverage your property manager. Use his/her experience in the market to give you their best estimate. Your property manager is renting hundreds of units per year. So he/she should be able to give you the most accurate estimate. A good property manager will understand market forces (e.g., time of year, current demand, job growth). They should also take into account the quality and location of the home. Don’t rely on your real estate agent alone for this information. Your property manager is the expert. Therefore, we would highly advise consulting with them prior to making an offer.
What do you do if you are new to a market and don’t have a property manager? There’s no reason you can’t establish a relationship with a property manager before buying in a new market. Most property managers would be happy to provide you with rent estimates for properties you are considering ahead of purchase. If they aren’t willing to do so, you probably shouldn’t be using that property manager.
A couple of years ago, for example, we entered a new market in Spokane, WA. When we met with our property manager for the first time, we showed him the MLS listings for a few properties we were considering. We found a duplex renting for $750 a month on each side. Which seemed low to us. When we presented the information to our property manager, he was able to tell us that it should minimally be rented for $900 a side. He came to this conclusion, even without seeing the property in person. Then, within a couple of weeks of buying the property, he had rented each side for $925 a side with <$2,000 in repairs to get the property ready to rent.
Find an Extra Bedroom (or Two)
I recently read a book by a real estate investor who figured out he could charge approximately $200 in additional rent for each bedroom that he added to his units. He then focused on buying only three-bedroom properties that had space to add a fourth or fifth bedroom. The exact amount of additional rent may differ in each market. However, there is no doubt that making use of unutilized space for an additional bedroom or two, will allow you to increase rents.
So where do you look for unutilized space?
Keep an eye out for unfinished basements, back porches, or even garages that could potentially be converted into an extra bedroom. For example, we’ve been able to add extra bedrooms to our units in poorly utilized spaces such as oversized laundry rooms and basements. Oftentimes, all it takes to build a bedroom is to add a wall and a door. Sometimes you have to add an egress window and a closet, which can be done at a minimal cost.
In the case of one of our units (see picture), we converted an oversized laundry room into a third bedroom. Notice in the picture that the room already had an egress window. We easily added a closet by using extra space taken up by an old water heater and replacing it with a smaller, new one.
Recognize the Ability to Add an Additional Unit
Though this opportunity arises less frequently than finding an extra bedroom, sometimes you can add an independent rental unit to an existing building. Some good places to look are above a garage, in an attic or in a basement. Creating an additional unit will add significantly to your renovation cost because you’ll need a kitchen and bathroom, but doing so can exponentially increase a property’s return. If you’re able to spot an opportunity like this before purchase (and have favorable zoning to allow for this additional unit), you can increase a property’s cash-on-cash return significantly.
We did this recently with our 16-unit multifamily property. There was an oversized laundry room and storage area, which we converted into a smaller laundry room and a small one-bedroom unit. With the additional rent the unit will generate, we easily added over $200,000 to the value of the property!
Rent a Detached Garage Separately
In certain markets, detached garages can be rented to individuals who are not renting a unit in your property. Generally, people who rent garages live close by and use them as a shop or for storage. One of the only real expenses is to have a separate electrical meter installed. We found that you can get significantly higher returns this way because the space can be used as a workspace, not just storage.
We have been renting out three of our detached garages, ranging from $100-400 per month in Spokane and Seattle. Two are rented out by our property managers. We are using Neighbor.com (This is our affiliate link. If you use it you will receive a $50 gift card) for the third garage.
When we first approached our property managers about renting garages several years ago, they had never done it before. Over the last couple of years, they have become proponents of the practice. It aligns nicely with our mutual goal – to increase property income!
Neighbor.com is a nice alternative to using a property manager. We wrote about our experience using this online service for renting out spaces in a separate article.
Identify Unused Storage Units
Storage units can pack a big bang for the buck in rental properties and are a great way to increase rental income. If you know the demand for storage units in your market and their rents, you may be able to build in assumptions of storage unit income into your initial cash-on-cash estimates to see if the property will meet your financial goals.
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Many properties have built-in storage units. These are frequently given away for free to tenants. But what if you charged for the storage space instead? You would increase your rental revenue without adding any additional costs. In other words, any rent you collect would be pure profit.
Find Space to Add Storage Spaces
In one case, we acquired a property with an existing large metal storage shed, built by a former tenant. The owner asked us whether or not we wanted her to remove the shed before we purchased it. Instead of clearing it off the property, we decided to keep it with plans to rent it out. We were able to rent it out to one of our new tenants for $30 per month. In another case, we purchased a property with a small sunroom. We converted it into two storage units and rented it to the tenants.
An alternative to this would be to build a free-standing storage shed or buy one that is pre-assembled. These work well when you have a large driveway and one can easily be constructed on the existing concrete slab.
We implemented this plan in the driveway of one of our duplexes. This particular unit had an oversized driveway with space for about 10 cars. We decided to take advantage of the extra space. We added two small storage units that we purchased for around $2,000. Then, we rented them to the tenants for $75 dollars a month ($900 a year) for a 45% annual return. At that rate, we paid off the storage units in a little over two years. Whatever rent we collected after that point was pure profit.
Find Hidden Value from Unutilized Land
Excess land can sometimes be a great source of hidden value as a way to increase rental income.
This land can be subdivided and sold off, allowing you to recoup a significant portion of your initial investment. This would leave you with a cash-producing property with a minimal initial investment.
One of our investors did exactly this. She bought a duplex with a large plot of land. She subdivided the land into two pieces and sold the land. This almost paid for her initial investment in the property. She now owns a cashflowing duplex and her initial investment is nearly zero!
Another option is to subdivide and build separate residences. We shared our experience subdividing land so we can build two new duplexes (a total of four units) in a prior article.
Another alternative is to add an accessory dwelling unit or even add tiny houses to increase rent monthly income. The beauty of this approach is that you probably don’t have to go through the effort of subdividing the land.
Recognize the Opportunity for Zoning Changes
Zoning changes can also help you realize the additional value in a property.
For example, changing a property’s zoning from multi-family to commercial is one opportunity.
Some call this “upzoning.” This means that with zoning changes, there’s an opportunity to upgrade a single-family home into a higher-value multifamily dwelling.
We attempted to do this with one of our properties. It was situated one block from a major thoroughfare. So we thought there would be a good chance for an upzone. The property was a single-family home but it was situated on three lots. This would give us an opportunity to build a multi-story, multifamily property if the zoning changed to commercial. While it hasn’t been upzoned yet, the property continues to cashflow in the meantime. It’s hidden value can be tapped into sometime in the future as a way to increase rental income.
To find hidden value and potential in land and zoning changes, you must have familiarity with zoning or ground-up construction.
Get Rid of Utility Charges
Many cost-cutting initiatives require in-depth analysis of expenses. This isn’t something you’ll normally do when you’re screening properties. Instead, you’ll often do this detailed analysis after purchase.
One exception is utilities. Most multi-family property listings on apps such as Redfin or Zillow, include information about utility costs. You can use this data in your initial screen to recognize hidden value.
One of the easiest ways we’ve found to get properties above the 1% rule, is to recognize when the market will allow for billing utilities back to the tenants. We have utilized this approach with all of our properties. In some cases, we have bought properties with >$600 a month of utility costs, all of which we have been able to bill back to the tenants.
This is equivalent to increasing cashflow from the property by greater than $7,000 per year. That’s a huge increase in cashflow. If you know that you are in a strong enough rental market to be able to shift the cost of the utilities to your renters, you can factor that into your cash-on-cash calculations prior to buying a property. If you want to learn more about the different ways to bill back utilities, check out this article.
Find a Different Customer
This one is a different way to increase rental income that even experienced investors miss.
The idea is to find a higher-paying customer. Why settle for a lower-paying customer when someone will pay more for the same unit?
Students in our courses have done this successfully with many different types of customers.
One example is Section 8. Certain markets will pay more for a property than you can get for a regular tenant. You just have to know the rates they’ll pay for a property relative to the market rent.
Another example is supported living. This is State-funded housing for people with intellectual disabilities. This isn’t available in all markets and it’s not always more lucrative than renting to regular tenants. However, when you find the right situation as we did in Spokane, your cashflow can far surpass what you can get with a regular tenant. If you want to read about how we generate 40% cash-on-cash return with supported living, click here.
Sometimes You Won’t Get There…. and Sometimes You’ll Hit a Home Run
We’ve just spent a lot of time covering how to get your properties to meet your cash-on-cash criteria through hidden value prior to purchasing. Now, for a reality check.
Sometimes you won’t get there. You’ll buy a property with plans to increase cashflow. Then you’ll run into roadblocks or something won’t be rentable or there will be a market downturn. The fact is, some of these things cannot be anticipated. And the fact is, nobody is perfect. So sometimes you won’t reach your cashflow goals.
We, for example, have properties that we’ve put a large sum of money into fixing up. These are running closer to 8% cash-on-cash currently.
But the opposite is true as well. Sometimes you’ll buy a property, and you’ll find you can add on extra value in ways you didn’t initially consider. Or the area may become hot and rents increase at a far greater rate than you initially expected.
Key Takeaways
Real estate investing using the buy and hold strategy is about playing the long game and looking across your portfolio, knowing that some properties will underperform while others far surpass expectations.
The great thing about it is that you can improve your portfolio over time. You can sell properties (the underperformers and maybe even the ones that happen to have crazy appreciation) and use a 1031 exchange to swap it for a better property. You can also learn from your mistakes and get better over time. The key is not to beat yourself up and quit. Instead, use your mistakes to become a better investor and to help others become better investors too.
