“Slowdown? What slowdown?” Want more articles like this? Create an account today to get BiggerPocket's best blog articles delivered to your inbox Sign up for free Many of us who experienced the last crash heard comments like this from 2004 right up through 2008. Though some investors sensed what was coming, the majority did not. In fact, many of us paid a dear price for our blindness. Last spring, I interviewed Daniel Ameduri, who was one of the people who warned the world of the coming doom. Yet amazingly, he lost his shirt in the downturn like so many others. It turns out that while he was wisely sounding the siren, he thought he could squeeze in one or two more deals before the crash. To his demise. I admit that I did something similar. The signs of the slowdown were crystal clear. I read the cover story in Fortune magazine, and even kept the magazine in my file for posterity. But I ignored its warning. The pain and loss I experienced led me to a whole new life and a whole new investing strategy. It also led me to a plan to avoid the same mistakes next time. I’d hate to sound like another guru: Someone who’s selling a secret get-rich-quick scheme — a recipe that will assure your wealth in any economy. I’m not going to do that. But I am going to tell you about a tangible strategy that many have used to grow their wealth in nearly any economy. It’s called… Value-Add Multifamily Investing Value-add is probably a familiar term to many readers, but not all. I promise it will make intuitive sense in a moment. Note that the value-add play is not the only way to profitably invest in commercial multifamily units. One could invest in new development, unstabilized properties, momentum plays, or other opportunities and do very well. But at this point in my career, I really like low-risk, stable, careful, and predictable deals. So for me, the stabilized value-add play ideally fits the bill. The simplest way I can quickly explain the value-add opportunity is buying an asset that has a given, known return on investment (ROI) and meaningfully improving some aspect of the property in a way that the ROI on the improvements is much higher than the ROI on the asset as a whole. In other words, meaningfully raising the average ROI on the entire project. Related: The Ultimate Metric You Need to Find Value-Add Apartment Deals OK, maybe I need to streamline this a bit. The buyer of (or investor in) a value-add asset recognizes some meaningful shortfall in the asset. He or she dispenses time and money to make improvements that raise the rents and/or net income on the property, making the asset more valuable as a whole. Value Add IRL How about a real example? Here’s one, simplified. Last spring, my firm tried to buy a 130-unit property in the Plaza-Midwood neighborhood east of downtown Charlotte, North Carolina. This complex was built in the mid-80s, and it showed. Except for a handful of units, these apartments had barely been remodeled since they were new. The appliances, countertops, lighting, flooring, and cabinets were seriously outdated. The average rent on these apartments was $729 per month, and they were almost completely rented. Plaza-Midwood is one of those cool areas of town that Millennials are eager to live in. Developers had built a few new apartment projects nearby, and they were renting for $1,200 or more per month. At least half a dozen older apartments in the area had been significantly rehabbed, and those rented for $850 – $950 per month, on average. These were our comps (comparable properties). We toured several of these properties while gathering property and rent information. The square footage, amenities, location, and sizes were all similar. The differences were all cosmetic. The comps had updated flooring, lighting, cabinets (doors and drawer faces), countertops, and appliances. They also had nicer landscaping, signs, etc. It was time to analyze. Adding the Value The rough cost to update these amenities in our subject property came to $5,500 per unit. It would have cost a few thousand more if we were to upgrade to granite countertops and entirely replace the old cabinets (rather than just the faces). We believed we could easily raise the average rent by $100, to $829, by making these changes. Enter the cap rate. The cap rate, expressed simply, is the ROI on the property. This can be calculated by dividing the net operating income (NOI) — not including debt service — by the cost to purchase the property. The cap rate for a property like this, at this time and in this location, was about 7 percent. The gross annual rents and other income on the property totaled about $1,090,000 (about $8,385 per unit, per year). Operating costs were about 50 percent ($545,000), leaving a NOI of $545,000. Dividing the NOI by the cap rate of 7 percent resulted in a purchase price of about $7.8 million. (The value of a commercial multifamily is generally based on the income stream, not comparables or replacement cost.) With 130 units, the cost per unit was about $59,900. As mentioned, we estimated that spending $5,500 per unit on upgrades would drive a rent increase of $100 per month ($1,200 annually). This would bring the gross annual rent per unit to $9,585 per year with no increase in operating costs. The ROI on the improvements is calculated by dividing $5,500 by $1,200, which comes out to almost 22 percent. This is more than three times the ROI (purchase cap rate) on the property (7 percent), so it creates a net increase in property value. Related: 3 Immediate Ways to Add Value to Your Multifamily Purchase How much? The new gross income on the property would be about $829 x 125 units (accounts for vacancy) x 12 months = $1,243,500. Subtracting $545,000 in operating expenses leaves an NOI of $698,500. Dividing by a 7 percent cap rate produces a new property value of $9.98 million. This is an increase of almost $2.2 million in value — close to $1.5 million net after the cost of upgrades. All things being equal, this would go directly into the owners’ collective pockets. And this doesn’t include significant cost-saving measures we could implement to improve the net income further. The value-add strategy is based on the fact that the ROI of the upgrades is much higher than the ROI on the property in general. Performing Tests It is important to understand that these upgrades may take a few years to implement, since they are generally undertaken when tenants move out. It’s also key to test these rehabs to assure that they will improve rents as much as you suspect. Asset managers may test different combinations of upgrades to see which produce the most rent growth. Sometimes property managers show a few of the upgraded units to tenants who have given notice to move out. Oftentimes these tenants are willing to upgrade and pay the additional rent and stay at the property. This is a double bonus since now tenants are retained with no marketing costs. These tenants can be excellent test cases to determine which improvements are most valuable. It is important to always give the majority of the weight to those who vote with their wallets, not just their opinions. Selling a Value-Add Property But wait. Why would an operator/seller leave this type of value-add opportunity for a new buyer? Why wouldn’t they do the work and enjoy the increased income and value themselves? There are a number of potential reasons. In the commercial lending world, loans are typically structured as balloon notes, so they have a set date for when they must be paid off. This means the property must be refinanced or sold at a certain time, or the owner chooses pre-payment penalties (if sold too soon) or potential default (by not paying off or refinancing). If the owner decides to sell, he may not have time to make all of these changes. Especially since most of these updates are only done when a unit is vacated. Even if the property is profitable, the owner may be unable or unwilling to provide the capital necessary to undertake these improvements. It is generally not advisable to use operating profits to make capital improvements, especially when there are investors who expect a regular yield. Remodeling is a hassle, and the owner and/or property manager may not want to undertake it on a large scale. Remodeling can mean down units, which means no rent. This is very significant in the year or so before a sale. Why? The value of the asset is based on the income, and buyers typically look back at least 12 months. A value-add opportunity can generate more interest among buyers. A status-quo property, sometimes referred to as a momentum play, can bring a yawn from the buyer community. But when buyers know they can undertake improvements that can give them a nice bump in value, more buyers are willing to bid, which can drive up the price relative to the income. Given these factors, when a buyer is preparing to sell, he or she will often remodel a handful of units as a test case. This will prove to the buyers what they can expect if they remodel the balance of the units. This is what many buyers, including our firm, look for. One More Thing To Consider Don’t confuse deferred maintenance with a value-add opportunity. A property that needs extensive roofing, gutters, landscaping and siding may be less appealing and therefore may possibly suffer from lower occupancy. But spending a boatload of cash to fix these things will not necessarily provide a predictable increase in rent. And don’t necessarily think that every meaningful upgrade will bump up rents. In the hipster Charlotte neighborhood I mentioned, an $800 washer/dryer hookup can drive $50 in additional rent (that’s a smokin’ hot 75 percent ROI ($50 x 12 = $600 ÷ $800 cost). This could end up adding about $1 million to the value of the 130-unit complex ($600/year x 130 units x 90 percent occupancy ÷ 7 percent cap rate). But an $8,000 playground would add little value in the minds of most of these millennial residents. Instead, I’d advise my asset manager to use the same amount of cash and dirt on a bark-park for little Fifis. But that theory would need to be tested as well. [Editor’s Note: We are republishing this article to help out our newer readers.] What about you? Do you have a value-add success (or failure) story to share with our readers? Do it below!