We recently had several apartment sales where the properties were in similar locations and had very similar sizes and building types.
Both the buyers and sellers were asking the question: why does one property sell for a much higher price per unit than the other, when they’re both so similar in size and location?
Most investors are familiar with the 1% rule, which helps with quick decision-making. This rule says if the monthly rent is 1% of the unit price, it’s a good buy, and you should move forward.
These days, finding a property that hits the 1% rule is tough. But more importantly, this guide leaves a lot to be desired — it fails to account for the expenses of the property, and it leaves out the improvements that may be needed.
Let’s look at two reasons why Net Operating Income (NOI) is a better measure than the 1% rule.
1. NOI Takes Into Account the Expenses
Let’s say Property A on Happy Days Avenue is a 10-unit building. The average rent is $1,045, and the property sold for $112,000 per unit.
$1,045 / $112,000 is 0.93% — almost 1%. Great deal, right?
Then Property B, on Cemetery Avenue, is also a 10-unit building that just sold. The average rent is $1,136, and it sold for $144,000 per unit.
$1,136 / $144,000 is 0.78% — a lower rent ratio.
So according to this, Property A on Happy Days Avenue is the better deal, right? Not quite — that doesn’t take into account the NOI of the property.
- Both Property A and Property B sold for the same cap rate, which makes sense, since they’re very similar in many aspects.
- The reason Property B on Cemetery Ave sold for much more per unit — and was still a great deal — is that its expenses are far lower. Cemetery Ave has all utilities metered separately and billed directly to the tenant.
- Ability to upgrade: some improvements, like separately metering utilities the way Property B did, can increase NOI. That resulting increase in income is a great reason to pay more for a unit.
- Even if you pass on a utility fee or some other charge, it’s still hard to counteract a rising cost the owner pays for. If the utility cost goes up but you’re charging tenants a flat rate, the owner has to eat that cost. With a separate meter, the tenant eats the cost instead, and the owner enjoys the same net rent.
- Tip: can’t sub-meter your property? Try a RUBS program to bill back utility usage as the next best thing. Some states limit RUBS programs, but most allow it as long as the landlord isn’t profiting from the program, and is only charging for actual utility costs.
2. NOI Accounts for Property Condition and Maintenance
Some investors buy a property, milk it for cash flow, and sell it without ever investing in capital improvements, updates, or non-emergency maintenance.
When it comes time to sell, this shows up for the buyer, and they have to factor the cost of those improvements into the price. Items like the roof, windows, and water heaters don’t increase the rent you can charge, so they don’t add to income value directly — but they still have to be done over time.
- The type of property matters here too. If it’s an older building converted from a large house into multiple units, the units are likely all unique layouts, and overall maintenance is trickier.
- A purpose-built apartment building, on the other hand, is usually easier to maintain — you can predict that the same replacement part or cabinet will fit every unit, since they’re all the same, without the fitting problems you might run into with a converted unit. So if you compare a purpose-built property to a converted one, the purpose-built property should sell for more, thanks to the ease of maintenance.
Maintenance is another reason Property B sold for more than Property A. When maintenance items go unaddressed, they decrease the new owner’s return until they’re resolved — leaving the owner with a diminished return for longer.
It’s a Wrap
At the end of the day, buyers are purchasing income! Say it with us: income.
That income over time will always drive value — whether you measure it in price per unit, NOI, or the 1% ratio, Net Operating Income leaves the others in the dust.
We help many investors focus on the income stream that best meets their long-term investment goals. If you’d like a free opinion of value for your investment property, or you’re looking to grow your investments, contact us to get started.
