This is different from the substitution principle applied to residential real estate or single-family rentals.  The substitution principle basically says a house is a house and all else being equal there are minimal differences between your property and your neighbor’s if the two houses are in similar locations, similar sizes, age, construction quality, etc.  In residential, your value is based on comparable market sales from your neighbors.  So if they are selling properties while distressed (perhaps a death, or divorce) it negatively impacts your values.  Or if a house is foreclosed in your subdivision, your value is decreased.  That’s crazy logic.  Regrettably, it’s also how our residential mortgage market determines values they will loan. 

Multifamily allows us to force appreciation by being strong operators of good businesses.  Unlike residential, banks loan to Multifamily on values of real income and expenses.  So, we stand on our own business operations and successes rather than our neighbors.  Forced appreciation occurs constantly with changes that grow revenue while not growing expenses, such as increasing average rent. 

Here’s an illustration of forced appreciation

Buy a property with an average monthly rental rate of $1,000.  We have 100 units with Operating Expense of  $50,000 per month.

NOI = $1000 *100 = 100,000 -$50,000 = $50K per month or $600K / Yr  / Cap Rate of 5% = $12M valuation

We increase average unit rate $100 by adding Washers and Dryers to each unit,

$1100 x 100 = $110,000 -$50,000 (no operating expenses were changed by adding W/D) for $60,000 / Month, $720,000 / Cap Rate 5% = $14.4M

Simply adding 100 Washers and Dryers ($120K from a CapEx budget) will yield an increase in value to the business of $2.4M or 20% with only a 10% increase in income.  This is the power of forced appreciation via Cap Rate values.  Adding a Washer / Dryer to a single family rental will increase your value by $1,200 if you achieve the $100 rent bump.  Multifamily SCALE wins EVERY TIME. Appreciation ultimately turns into Capital Gains, which are taxed, so let’s look at how we defer tax burdens. 

We utilize cost segregation, an accounting methodology, which allows us to allocate various components of the building, real estate and purchase to different “buckets.” The “buckets” are real property and personal property.  Here we get into technical definitions that are specific and laid out by the IRS.  We hire 3rd party firms to do an analysis and at the end we have all property allocated to these buckets.  We then depreciate them over a specified schedule of years.  With Bonus Depreciation we can allocate 100% of the value of certain property types against the first year in service.  (Note: in 2023 this tax problem starts stair-stepping down by 20% per year, so in 2023 we can use Bonus Depreciation of 80% in Year 1)  What this means is that for some of our investors, we can deliver an accounting loss that can offset accounting gains.  There are lots of nuances to this; top-line is that we often deliver losses in Year 1 that are able to be applied against gains and your investment growth might be offset by tax losses from Cost Segregation.*  

*MAC Assets is not a law firm or a CPA and does not offer any legal or tax advice.  Always consult with a tax or legal professional when considering an investment decision.