Value-add multifamily investing has long been an attractive strategy for real estate investors. With no ground-up construction risk involved, an investor has a chance to make an existing apartment complex more profitable via various renovations. These renovations can include upgrading to stainless steel appliances, installing in-unit washer-and-dryer units, adding a gym, or perhaps improving the exterior area of the apartment complex (adding more light, updated parking spaces, new playground, etc.)
Value-add multifamily investing works by increasing the property’s net operating income (NOI). Increased incoming cash-flow results in a higher NOI figure, which in turn raises the asset’s market value.
In this article, we’ll explore two key points of value-add multifamily investing that you must be aware of before considering this strategy: (1) Creating increased cash-flow in a short time frame and (2) The importance of having a strong, reliable property manager.
- Creating increased cash-flow in a short time frame
During your underwriting stage of a particular asset, you should examine the units and see whether there is an opportunity to grow the rents. This can be done by comparing the subject property’s rents with its peers in the same sub-market on sites such as apartments.com or hotpads.com. Make sure you pay attention to the absolute dollar rents per a given bedroom (i.e. $800 for one bedroom, and $1,100 for a two bedroom), as well as dollars on a per square foot basis (i.e. $2/square foot for one-bedroom apartment, and $1.60/square foot for a two bedroom apartment). This is important because a 700 square foot one bedroom is not expected to rent for the same amount as 950 square foot one bedroom in the same market.
Assuming that the asset is currently priced below its peers, there may be an opportunity to raise rents via a value-add program. One thing to note – when looking at peers, make sure you’re looking at apartment complexes of a similar age (i.e 1980’s or 2000’s product, whatever the case may be).
The next step is to examine the cost of value-add implementation. For example, let’s say you are looking at purchasing a 50-unit apartment complex for $5 million, that generates $250,000 of annual NOI, which translates into a 5% cap rate. Having done your analysis, you believe that through implementing a value-add program that would cost you $250,000, you will be able to increase the annual NOI to $300,000. If you apply a 5% cap rate to that newly created $50,000 of NOI, you will get $1,000,000 of value creation. In other words, assuming you can raise rents and achieve a new NOI of $300,000, you should be able to sell the property for $6,000,000. Given that you purchased the asset for $5 million, and spent $250,000 on various improvements to the asset, you would stand to earn approximately $750,000 on your investment. This can often be done inside of 18 months, since you’re not dealing with any ground-up construction and are improving an existing asset.
It is also important to point out that your original acquisition price of $5 million was likely 70% financed by debt, meaning you only had to come up with $1.5 million in equity. After repaying your debt and accounting for transaction costs (let’s say $150,000 in this example), you will have made an approximately $600,000 return on your original $1.5 million of investment – a good pay-day for your investors.
- The importance of having a strong, reliable property manager
The truth is, value-add investing is often done by out-of-state investors, so having a property manager who you can trust is paramount to a successful execution of your plan. Essentially, you will need your property manager to work with the general contractor and monitor the progress of the renovation work. This is easier said than done. Working with general contractors requires understanding the work-flow involved, the underlying expenses, and making sure that the general contractor executes according to plan. You would need to find a property manager who will be willing to monitor such renovation work (for a fee).
After the renovation work is complete, your property manager will need to successfully raise rents across your units. This means making sure your existing tenants do not balk at increased rents, as well as locking down new tenants at often meaningfully higher rent levels. The bottom line is, make sure you do your diligence to get comfortable with the property manager that you would be getting in bed with.
In conclusion, value-add multifamily investing often provides compelling risk adjusted returns. Sponsors get to benefit from increased rents, higher NOI levels, and often lower cap rates post-rehab. Make sure to partner with competent general contractors and property managers to help you execute on a successful value-add strategy.