Value Add vs Turn Key: Which One is Better?
Generally speaking, there are two main strategies when buying multifamily properties: Turn Key and Value Add. These strategies are very different and both have pros and cons.
In a turn key investment, the buyer does not plan on making any significant changes to the property. They might change the property management company, but the property simply changes hands and everything else stays the same: the rents, design, amenities, etc. Turn Key deals usually provide lower returns. Value-Add, on the other hand, is a very popular type of investment today, and I usually do not consider deals that have no value-add component. In a value-add deal, the buyer is looking for a way to increase the property’s profitability. It can be done by applying any of these methods:
1. Renovating the amenities, property exterior or units and increasing rents.Syndicators conduct a market research and analyze nearby buildings with similar vintage (age), amenities and renovation level. If they find that a property is charging rents that are lower than the comps, then it is a great opportunity to renovate the building and increase rents to match the nearby, nicer buildings. The gap between the current rents and the new, higher rents is called the “premium.” Some of the most popular value-add strategies are:
a. Renovating the unit’s interiors (kitchen, floors, bathrooms, paint throughout the unit, etc.)
b. Adding washers and dryers to the apartments
c. Adding reserved parking
d. Renovating or adding new amenities (gyms, package distribution center, dog parks, etc.)
2. Finding a property that has below market rents and increasing them to match market rents. Some properties are charging lower rents than similar competing properties that have similar amenities and renovation level. It usually happens because of one of the following reasons:
a. An inexperienced property management company who does not understand the market.
b. Mom-and-pop operated properties where the owners are afraid the vacancy will drop due to increasing rents.
3. Applying a RUBS plan to charge tenants more for a more accurate use of utilities.Ratio Utility Billing System (RUBS) is a system through which the owner can bill back the tenants for their utility usage based on formulas that take into account the unit size and number of occupants. RUBS is a more accurate way to bill tenants on their utility consumptions and helps to increase income and reduce expenses.
4. Bringing in a new property management company to manage the property more efficiently and reduce costs. In multifamily properties, the income to expense ratio is anywhere from 45% to 55% (for 100 units and above). A great value-add opportunity is a property that is mismanaged and its expenses are higher than they should be. If an investor can find a property that is managed on a 60% expense ratio and can lower it to 55%, they can increase the cash flow from the property and the building’s value as well.
Since a multifamily property’s value is mainly based on the property’s income, by adding value and cutting costs syndicators can sell the property for a higher price after holding it for several years. That is the main reason why many investors, including myself, are focused on value-add deals.
A final word of caution: not every property is suitable for a value-add plan. Even the nicest apartment cannot guarantee that someone will want or be able to pay the premium to live in it. A good value-add candidate is one who is in a strong area where people with sufficient income live and can afford to pay for the upgraded unit.
So Which Strategy Is Better?
When investing in renovated units and amenities there is always the risk of not being able to charge higher rents (a shift in the economy, mistake in pricing, etc.). This risk does not exist in a turn key deal. However, your value-add deals provide higher returns than turn key deals, and for good reason. An investor that is willing to put the time, money and effort to improve the property will be rewarded, as long as they know the area and the property well.