How to Beat the Coming Housing Slowdown With a Value-Add Multifamily

by | BiggerPockets.com

“Slowdown? What slowdown?”

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.

  1. 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.
  2. 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.
  3. Remodeling is a hassle, and the owner and/or property manager may not want to undertake it on a large scale.
  4. 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.
  5. 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.

What about you?

Do you have a value-add success (or failure) story to share with our readers? Do it below!

About Author

Paul Moore

Paul is author of The Perfect Investment - Create Enduring Wealth from the Historic Shift to Multifamily Housing, which you should probably get if you want to learn to invest in multifamily. He leads Wellings Capital , a multifamily investment firm, and hosts the How to Lose Money podcast. Paul was 2-time Finalist for MI Entrepreneur of the Year, has flipped 60 homes and 30 waterfront lots, developed a subdivision, and appeared on HGTV. Paul's firm invests heavily to fight human trafficking and rescue its victims.

35 Comments

      • Paul Moore

        Yes Brian. I was not clear on that in the article – my apologies to you and everyone. What I meant was this…

        In an economic downturn, the value of a property may go down. Say by 10%. By “forcing appreciation” through Value-add upgrades, we can overcome that drop in value.

        From my article: “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.”

        • Jonathan Allen

          Hi Paul – dumb question here.

          When you talk about “producing a new property value” or value going directly in owners pocket, how are you actually monetizing this?

          I.E. I understand your cap rate math and new value, but if you don’t actually sell the property, other than mental math, how are you suggesting this protects you or makes you the net increase in value.

  1. Adrian Tilley

    Paul, good article. How do you estimate Roi on specific projects, especially smaller ones like adding a washer dryer hookup? Is it just from knowing many of the properties in the area and analyzing the differences between the properties and the rent amounts?

  2. David Thompson

    Paul,
    You are a master my friend. Well laid out article and easy to understand. In Texas, we are seeing good opportunities to add value / revenue generations through covered parking (carports) and first floor fenced patios that add about 100sf to the apt. Folks seem willing to pay $25 – $35 /mo on covered parking and about $50 more for fenced in yards for addt’l privacy and pet relaxation zones. Dog parks are an amenity easy to add, high in demand so we do add those if we have the space.

  3. Leo Bach

    Very much enjoyed the article, Paul!
    This has clarified my understanding of how investors evaluate multifamily units.
    I don’t know why it wasn’t self-evident before but it makes total sense to make upgrades based on their ability to increase the value of each unit. Anyway, thanks for sharing this knowledge with everyone!

    I am very green behind the ears so perhaps this is an amateur question but:
    Can you help me connect the dots on how this approach helps protect or mitigate losses should there be a downturn in the housing/real estate market?

    Much Appreciated,
    Leo Bach

    • Paul Moore

      Thanks for the question, Leo.

      I was not clear on that in the article – my apologies to you and everyone. What I meant was this…

      In an economic downturn, the value of a property may go down. Say by 10%. By “forcing appreciation” through Value-add upgrades, we can overcome that drop in value.

      From my article: “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.”

  4. brian ploszay

    Respectfully, I am a contrarian. A slowdown in multi family sales and achieved rents has already begun in many markets. Apartment building prices are extremely high, so it has been said that this is not the time to put together an apartment portfolio.

    If there is a recession, it is true that apartments fare well.

    • Paul Moore

      Brian:

      I completely understand, and you have reason to be. The market is over-heated, and it is very hard to get a good deal, far less a portfolio.

      But great deals are still out there. We found one, and we plan to close in November.

    • Paul Moore

      Hi Ilana,

      I was not clear on that in the article – my apologies to you and everyone. What I meant was this…

      In an economic downturn, the value of a property may go down. Say by 10%. By “forcing appreciation” through Value-add upgrades, we can overcome that drop in value.

      From my article: “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.”

        • Paul Moore

          Douglas.

          I feel like I have, but maybe not so clearly. I’m saying that if you can meaningfully increase the ROI of a certain aspect of the business through value-add, that raises the blended average ROI of the property. Then in a downturn, when rents or value drop, you have some cushion.

          So if my property is operating at a 6% unleveraged ROI (aka cap rate), and you can invest $4,000 in each interior, and that raises rents $100 per month ($1,200/year), the return on those value-add improvements is 30%. This may raise the blended ROI on the property from 6% to (say) 8%.

          Then this gives us extra profit in the case of a downturn.

          I hope this helps. Thanks for your comment.

    • Paul Moore

      Andy,

      Yes, that is super-important. Sometimes hard to know the difference. On the apartment asset we are acquiring in Lexington, KY right now, we have to do quite a bit of deferred maintenance to get the value out of the value-adds that have already been done.

  5. Sonia Spangenberg

    Everything I have read of yours causes a significant increase in my knowledge base. All stuff I can implement even at my smaller operating level. I am learning to grow my weak area which is the math. Your explanations are easy to follow. Love working examples on my own properties. Love your firm’s cause too. Thanks for your contributions!

  6. dave atchison

    A great article by a smart man . Multi family should be the goal of all buy and hold real estate investors. Karma is real, a persons home is thier castle. If a real estate investor- property manager , can make all thier tenants homes or apartments feel like a castle… they create a win win for all involved.. I like b rated multi family.. the housing market will rise and fall.. people will always need an affordable roof over thier heads , and get your mortgage paid off while you all work together.. win – win

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