Interest rates are on the rise, which has some real estate investors concerned. Your property’s net operating income (NOI) can play an important role in the rate you’re able to get and in the overall success of your business plan. Learn more about maximizing your profitability in the face of rising interest rates.
How NOI, Capitalization Rates, and Interest Rates Are Related
NOI is an important part of determining a property’s capitalization (cap) rate. The formula for cap rate is:
Cap rate = NOI/purchase price
A cap rate is the unlevered (i.e., no mortgage) return an investor can expect based on the property’s NOI and purchase price. While cap rates serve as a snapshot of a property’s potential return, investors consider many other factors—including financing costs—when projecting long-run profitability.
Most real estate investors use mortgage financing, so interest rates (notably not included in NOI or cap rate formulas) should also be considered when projecting the investor’s internal rate of return (IRR).
In short, as interest rates rise, investors who are financing their properties through mortgages must pay less for a property in order to achieve the same IRR. These lower purchase prices are tied to higher cap rate percentages, assuming NOI remains constant.
The relationship among real estate investment metrics can be complex, but one thing is clear: An increase in NOI is always a positive because (all other factors being equal) a property that generates more income will generate a higher rate of return for an investor now and in the future.
How to Increase Net Operating Income
In spite of rising interest rates, the commercial real estate and residential real estate market has been performing well with record levels of occupancy and rents. However, some investors are missing opportunities to increase their NOI and, in turn, their ROI.
Optimize your property management.
If you’re buying a mismanaged portfolio with high vacancies, deferred maintenance, renovation needs, or other problems, you can benefit from a lower purchase price and take proactive steps to increase NOI.
First, make sure you have a great property manager you can trust. The right property management company can help you turn around the problems that are detracting from a property’s NOI to maximize rents and profitability.
Raise rents to match market norms.
Rent growth rose substantially in 2021, hitting a record increase of 10.9% in the third quarter. Rents have been up in response to the increased demand from more and more families and individuals who are choosing to rent instead of buying a home. Since the start of the pandemic, the number of renter households has grown by more than 870,000.
Especially if you’ve owned a rental property for a while, you may lose touch with current rates in the market for similar properties and end up leaving money on the table. A simple way to increase your NOI is to raise rents if you can while remaining within market norms. At Verus Commercial Real Estate Finance (VCREF), our team can help you determine how your rental rates compare to the rest of the market.
Improve marketing to attract ideal tenants.
Having the right tenants can make a major difference in avoiding costly problems such as evictions, property damage, and missed rent. Considering the increased demand in the market, you can afford to be selective in the applicants you approve to become tenants. Look for tenants with excellent credit and no history of previous evictions.
Of course, you must first attract these ideal tenants to apply. This will likely mean investing more time and/or finances into marketing. This up-front investment is well worth it if it helps you attract the right renters.
Update and enhance the property.
You can also raise rents and attract better tenants by making your property as appealing as it can be. Start by ensuring basic maintenance is where it needs to be. If there are any structural issues in your property, address these promptly.
You can also undertake renovations or cosmetic work to update and improve the property. Kitchen and bathroom renovations tend to offer the highest ROI, justifying increased rents and attracting more, and higher-paying, tenants.
Why Interest Rates Are Just One Piece of the Puzzle
Keep in mind that interest rates are not all important when it comes to profitability for a real estate investor. Even a higher-interest loan can be a smart move to help investors increase NOI and ultimately enhance their profitability.
Accepting a higher interest rate on a bridge loan, for instance, makes sense if it allows you to raise your property value and then refinance to a lower rate you lock in for several years. High interest rates in the case of bridge loans are very temporary, so it’s smart to think about the long-term benefits over the short-term cost.
When taking out a loan, investors should consider their overall business strategy and goals. Understanding the current market, including changes in interest rates, and remaining flexible is key.
Learn More About Residential Real Estate Financing
Increased NOI is a win for any real estate investor. Whether you’re looking to expand your portfolio or enhance your existing properties, single-family rentals (SFRs) have shown great promise for real estate investors in the current market.
Take a moment to learn more about investing in SFRs and financing these investments through the appropriate loan from Verus Commercial Real Estate Finance.