Cap Ex to Value

Last month we completed a cash out refinance on our 66-unit property in Dallas, Agave Azul. This capital event resulted in $1 million dollars being pulled out of the property, giving investors a 40% return on their investment in 20 months. We still own the asset and it will continue to produce cash flow for the investors on top of the 40% ROI received during the refi. I posted the picture below on social media when the cash out refi was completed which depicts the capital expenditure burn off over the first year of ownership and the rising value of the property during the same period. I figured I would take some time to explain in more detail how capital expenditures are converted to value.

What is capital expenditure (Cap Ex)? This is money used to improve the physical condition and operational functions of a property. The Cap Ex is raised from investors at the beginning of the deal and deployed to create better living conditions for the residents and subsequently increase rent. At Agave Azul we raised $1.2MM in Cap Ex to repair decades worth of decay. The exterior was painted, power washed, accented with cedar plank, and cleared of the satellite farm on the front of the buildings. Additionally, we replaced the perimeter fence, repaired the vehicle gate and added surveillance cameras to increase security, and added an outdoor kitchen for resident enjoyment. Interior improvements were all encompassing from conversion of window units to central AC, to new granite countertops, cabinets, flooring, appliances, paint, and everything in between. Given the choice, where would you rather live?

So then how does this $1,200,000 of Cap Ex get converted to value? Improving the physical condition of a property invites a higher quality resident who is willing to pay a higher price for a clean, safe, and desirable home. Rents at Agave Azul at take over averaged $0.78 square foot with all bills paid by the owner. During the first 12 months of ownership our Cap Ex plan was executed and residents in the market took notice. Over time more and more residents began shopping the property and started paying more in rent.

The first few months of improving a property, also known as repositioning, are extremely invasive. Construction crews are everywhere, dumpsters litter the property, and rotted wood and other debris lay waste throughout the premises. Needless to say, it can be unpleasant to live on site during this process, yet…people do. At a certain inflection point the property begins to take shape and early adopters can see the property improving. These early adopters are the first to move in and begin to prove the business plan is accurate. Suddenly the renovated one-bedroom unit leases for $0.85/sq.ft. compared to its classic counterpart which is stuck at $0.78/sq.ft. This rental increase happens over and over. With every new lease the property looks better and a higher rental rate is achieved. Eventually all the cap ex money is burned off and converted to property improvements, and ultimately every unit is leased by a new resident at a higher rental rate. Suddenly the previous rental rate average of $0.78/sq.ft. has blown up to $1.00/sq.ft. and utilities are now billed back to the resident at an average of $45 per unit. Value has now been created

You will recall from a previous post on cap rates that the value of a property is based on the net operating income of a property divided by the cap rate. For Agave Azul the increase in rent from $0.78/sq.ft. to $1.00/sq.ft. plus utilities caused an increase of $90,000 to the annual net operating income. Simultaneously, the property became more desirable due to its increased economic life and more responsible operational practices. The more desirable asset caused the going in cap rate of 7.7% to drop to 6.3%. Cap rates and value have an inverse relationship; increased net operating income with a compressing cap rate leads to higher value. All in all, the injection of $1,200,000 of cap ex resulted in an increase in value of $2,224,000 of which we were able to pull out $1,000,000 through the refinancing of the debt. And that, my loyal reader, is how you convert cap ex into value.

Disclaimer: Past performance is not indicative of future results. No investment is risk-free. You should not assume that any discussion or information contained on this website serves as the receipt of, or as a substitute for, personalized investment advice.