On the outside, distressed assets can seem like an investor’s dream. These properties are priced at less than market value and appear to be a real bargain. But many investors purchase a distressed property and have no idea how to turn it into a profitable investment. How do you determine whether an asset is really a bargain — or a disguised headache?
Where to Start
When we set out to buy a distressed asset, we begin by narrowing our target. Your target is typically determined by a certain return or yield requirement.
Distressed assets provide a higher yield, allowing you to make more money than you would with a nondistressed asset. This means that a nice, stable commercial property will sell at a higher price, but provide lower income or a lower capitalization rate (cap rate).
The cap rate represents your returns on the property and is calculated:
Cap Rate = Net Income / Purchase Price
So, a multifamily property that provides $50,000 of net income and costs $1 million pays a 5% cap rate.
However, a distressed asset can be tricky to assess at first glance because of its current, unstable condition. You might be able to add value to the property via a number of strategies and increase the property’s annual income, thereby increasing its value.
To be clear, whenever you purchase a distressed asset, it’s going to take a lot of extra time and money to increase its annual income. But if you master the process, the potential profits will more than offset the improvement costs, turning it into a profitable investment.
Here are five strategies you can use to increase a property’s net income. These strategies are a great place to start when trying to determine if you’ve found a profitable investment.
1.) Raise Rents
The simplest way to increase the income of the property is to raise the rent. This sounds simple in theory, but in practice can be very difficult. In fact, it is far easier to find a property that isn’t charging market rents and then raise them.
Many people get complacent when running buildings and don’t stay current with a rising rental marketplace. When looking at properties, start by conducting a rental survey, and check the rents of comparable properties in the neighborhood. Is your building charging below-market rents? If so, it might be a great opportunity.
In a recent deal, I bought 60 units of apartments that were each renting for $600 to $675 per month. With minimal investment, I brought the rents up to $950 per unit. This allowed me to resell the property for roughly 50% more than what I paid for it.
The entire process could take between 12 and 18 months, depending on the timing of the leases. You also must be careful, as this strategy depends on the assumption that rental rates won’t go down while you are holding the property.
2.) Increase Square Footage
Next, I examine options for increasing the property’s square footage. Properties with room to grow in size have room to grow in income as well.
Rent is typically calculated by dollars per foot, particularly in commercial space. So, the more space you add, the more money flowing in.
Assess if there are any parts of your potential investment property that aren’t being utilized to their fullest. Any unused space where you might be able to build? Can you be creative with the footprint of the lot?
Higher rents could offset the construction costs. Real estate is thriving right now, and you can build for less than the building is worth.
3.) Increase the Number of Units
This strategy follows the same logic as above: the more units, the more rent. But you don’t have to add space to increase the number of units. You can be creative with the square footage you already have.
Let’s say you have a large two-bedroom apartment that you rent for $900 a month. You could chop the apartment into two one-bedroom apartments and charge $700 for each. You just added $6,000 to your property’s net income.
It might take a little work and creative thinking on your part, but the potential payoff is high.
4.) Lower Expenses
Every dollar you shave off your expenses will grow the net income. While many of your expenses are necessities, you can still find ways to reduce your spending.
I bought a commercial building that was spending $1,200 a month on a dumpster. We switched vendors and reduced the frequency of pickups so that it was still sufficient for the property. In the end, we saved almost $10,000 a year simply by changing the dumpster.
Evaluate the different expenses that are decreasing the property’s net income and see where you can scale back.
5.) Improve the Efficiency of the Operations
When you increase the level of production, you will see a proportionate cost saving. In other words, the more efficiently a property runs, the more you will save.
Start by doing a thorough examination of the property management personnel. Are they efficient? Are they taking more than the typical fees? I once fired a company that was taking a large flat fee and found another company that was just as efficient and charged less.
Where can your property increase efficiency? And how much will that save you along the way?
These strategies for increasing a property’s net income are a great place to start when reviewing a distressed asset. By taking the time to review the property, you can assess its potential for profit and save yourself a lot of time and headaches.
Remember, distressed assets are distressed for a reason. Go into your investment with open eyes and a clear understanding of all the work ahead of you. The more prepared you are, the better chance you have to profit.