How I added over $750,000 in value in 18 months of ownership
We are approaching the Thanksgiving season and I thought I start off a little early with a progress of ownership and a big thanks to the whole biggerpockets.com family. @Joel Owens in particular.
I made my first real estate investment by house hacking a 3 Bedroom townhouse more than a decade ago.
After closing on my 4th single family rental, I started looking to scale into multi-family apartments. I couldn’t find any assets that met my buy criteria in my targeted zip code. My commercial broker suggested I look into other types of commercial real estate assets such as office, retail, mobile homes, storage, …etc. I was skeptical at first. But after losing on my n-th multi-family bid, I decided to take a much closer look at office buildings.
I spent lots of time on this site researching how to evaluate various commercial assets and specifically how to effectively implement value-add strategies. Thanks to the input from savvy investors , I fell comfortable with the idea of owning a value-add office building. In the summer of 2016, my broker presented me with a 17,500sf building in Raleigh, NC. It was being offered at $1,450 millions.
After some back and forth, I settled with the seller on a $1,350 million purchase price. I had never owned such a large asset before. However, thanks to biggerpockets.com, I had a plan in mind (and written down):
Reposition. Boost income. Reduce expenses. Convince good tenants to commit to longer term leases.
So in the fall of 2016 I took the plunge and closed on this massive purchase !!!
The Asset
The asset was a “typical value-add”. The owner had passed and the children inherited the property, but were not well versed on how to manage it efficiently. The curb appeal was really poor. Minimal landscaping was done. Rules and regulations were not enforced and there were broken down cars in the parking lot. Ownership had stopped performing necessary maintenance. No wonder, good tenants had left. Many leases were under market, year to year or month to month. About 70% of the building was leased, when I put the building under contract.
The Numbers
Getting a bank to finance the loan was a challenge. After a large number of denials, I finally found a bank willing to finance the purchase of the asset. I got a $1M recourse loan, 4.5%, 5 year fixed, 20 year amortization.
I won't mention the "purchase CAP Rate", because this number can be really misleading. Why? Although lease income as well as tax rate and insurance can be verified, Owners can write whatever they want in many expense columns. I focused on the potential income I could add and if I could keep the expenses around a certain percentage of income, then I had enough meat on the bones to make the deal
Asset Repositioning
After closing, one of my first moves was to let go of the current property management as they didn’t align well with my vision, my plan and my execution strategy. After multiple interviews, I settled on a smaller local PM that was willing to work with me hand in hand. I had a leasing agent, who worked with me through the purchase process and was extremely useful. I continued the repositioning by improving the externals of the building. Doing simple commonsense things made a big difference in the curb appeal: Trimming trees, installing new mulch, power washing the building, cleanup the parking area, common areas and trash area, installing parking violation, … etc. Then I worked on improving and actively enforcing the rules and regulations: Trash all over the place, smoking in building, dumpster, parking at the property was just wild and even dangerous.
Simultaneously I tackled deferred maintenance items. Many HVACs had reached end of life. The roof had leaking issues in many places. Additionally, late fees were strictly enforced. Offices with nicer views leased at a higher square footage price, tenant on short term lease (1 year) were asked much to pay higher sf prices. My leasing agent and I worked hard to get the building leased out. And by month 6 of ownership, we were 95% leased. Finally, in May (18 months into ownership), the building was 100% leased. With the exception of one tenant, all tenants are on multi-year leases.
The new building value
The new tenants income combined with the lease adjustments and rent escalations added close to $90k in new revenues from the time I made my offer to purchase.
An appraisal requested recently valued the building at roughly $2.1M, which is $750k above the purchase price.
However, I’m not yet done as there is still plenty of value to be extracted from this building. This is where the second part of the strategy comes in play.
Expense reduction
The building tax value was $1.9M at time of purchase. I filed with the county to have the tax basis match the acquisition price and it was approved recently, saving me roughly $5,000 in this year tax bill. In addition, all leases are full service, meaning owner pays all utilities and taxes, insurance … etc. An assessment showed, we could reduce it by roughly 40-50% with little investment. RUBS couldn't be implemented because of existing leases, so I went another route. All lightbulbs have now been replaced with LEDs, Photo cells have replaced timers, motion sensors have been added to all offices. In addition, we are taking advantage of a program offered by the local energy company to install Smart Thermostats in the building at no costs. Furthermore, as we replace older HVAC (expected Capex expense) with new ones, we are gaining more energy efficiency and lower utility costs.
Water conserving fixtures will be installed early next year. All the new gears should significantly reduce maintenance costs and overall utility costs.
NOI (Net Operating Income) Boost
Combining the tax savings, utility cost reduction, maintenance costs savings and lease escalation (up to 6%), the NOI boost is expected to be roughly $30k by the middle of next year when all leases turnover. At an typical 8 CAP, that's a value-add of $375k.
That’s like adding a new tenant at no cost !!! That’s the power of Value-add investing!!!
What I have learned so far?
Here some of the top 3 take aways from investing in this asset class.
Pros
- Yearly lease escalations is really nice.
- The tenant base is more sophisticated.
- Persistence in a good trait to have.
- Having a good team makes a big difference.
Cons
- It costs money to bring in new tenants
- The competition has lots of capital, but nothing beats knowing your turf very well
- Always read the details of leases (the tenant base is quite sophisticated)