The Basics of Value-Add in a Multifamily Investment
In the world of single-family homes, value-add is commonly referred to as fix-and-flip. You take a run-down property, reimagine it, invest money to rehab it, and sell it to a new owner for a profit. You receive a monetary reward for the work you put in and the risk you undertook, and the new owner gets a beautiful new property that’s move-in ready.
In the multifamily world, value-add is similar to the fix-and-flip model, but on a massive scale.
Instead of renovating a single unit, we’re often renovating hundreds of units, over several months or years.
A value-add multifamily property is one that comes with things like peeling paint on building exteriors, brown grass or overgrown bushes, kitchens with old appliances, and more. These are all cosmetic upgrades that can improve the community and increase the income the property produces.
The goal of every improvement is twofold. One is to improve the unit and community, for the tenants. The other goal is to either directly or indirectly increase the bottom line, for the investors.
Common value-add renovations can include individual unit upgrades, such as:
- Fresh paint
- New cabinets
- New countertops
- New appliances
- New flooring
- Upgraded fixtures
In addition, adding value to exteriors and shared spaces often helps to increase the sense of community:
- Fresh paint on building exteriors
- New signage
- Dog parks
- Covered parking
- Shared spaces (BBQ pit, picnic area, etc.)
On top of all that, adding value can also take the form of increasing efficiencies:
- Green initiatives to decrease utility costs
- Shared cable and internet
- Reducing expenses
- Increasing occupancy
- Utility bill backs
The Logistics of a Multifamily Value-Add
Most people are pretty familiar with the basic single-family fix-and-flip model at this point. You buy a vacant property, renovate it over the course of weeks or months, sell it, and the new owner moves in.
When we’re talking about hundreds of units, however, the renovation schedule and logistics aren’t as intuitive. How do you renovate the property when there are people living in it? Do you kick people out? How many units do you renovate at a time? All great questions.
When renovating a multifamily property, we always start with vacant units.
In a 100-unit property, a 5% vacancy rate means that there are five vacant units right off the bat, so our renovations begin there.
Once those are done, the goal is to renovate the large majority of the remaining units within the next eighteen months or so or within the timeframe that the execution of the business plan is calculated. This is done in a rolling fashion.
As each tenant’s lease comes due, we offer to move that tenant into an upgraded unit. We never kick anyone out of their homes. More often than not, tenants are blown away by the upgrades and are more than happy to pay a little extra to get to live in the brand-new units.
Once those tenants vacate their old units, the renovations ensue with freshly vacated units, and the process repeats until most or all of the units have been updated.
During the course of this process, some tenants do elect to move out, and we always factor into our business plan and projections a temporary increase in vacancy rates to account for the turnover and potential new lease-ups.
Why We Love Investing in Value-Add Properties
When done right, value-add strategies often result in a win-win scenario.
Through renovating the units, we can provide tenants with a nicer place to live (tenants win). And through increasing the rents to market rates, we can drastically increase the equity in the property (investors win).
The approach where tenants win is pretty straightforward – they have a nicer, safer, cleaner place to live. So let’s focus on the investor win, and why value-add can be a great investing strategy.
First, Let’s Talk about Yield Plays
To fully appreciate the benefit of a value-add investment, we should first examine the yield play investment.
Let’s say we buy a 100-unit apartment building that’s already in pretty good shape, and it gets decent cash flow as is, so we decide to just buy it and hold it, without doing much if anything to improve the property.
Essentially, we’re buying a stabilized property, and we’re investing in it for the potential yield down the road. This is called a yield play.
Perhaps the market might go up, and then we can sell for a hefty profit. But, there’s always the chance that the market will hold steady, or even contract, in which case we might not make as much as projected.
In a yield play like this, we’re buying a stabilized asset and holding it for potential future profits. The key word there is potential. We have no control over the local market and the economy as a whole; we can only base our projections on historical data and best guesses, which is why we aren’t “yield play” players.
In a yield play, the operator is depending on the market for the bulk of their investment returns. We don’t like speculating.
Okay, Now Let’s Go Back to Value-Adds
The opposite of a yield play is a value play, also called a value-add investment. Unlike a yield play, a value-add requires significant work (i.e., the renovations previously mentioned), and, as such, can also come with significant risk (more on this in a moment).
A value-add can also come with a ton of potential upside.
The main investor benefit in a value-add investment is that we, as investors, hold all the cards. We can actively do something (i.e., renovate the property) to increase value, rather than just sit around and wait for the market to appreciate.
By improving the property, we can increase the income, hence also increasing our equity in the deal. Remember, commercial properties are valued based on how much income they generate, not on comps, like single-family homes.
This gives us much more control over the investment and more control over the returns than in a yield play, which relies primarily on market appreciation for its upside.
Of course, the hybrid yield + value-add is ideal. This is when you invest in a value-add asset in a growing market. You have control over a certain amount of value that can be added, and you’re also in a market that will likely add some bonus appreciation on top of that.
Now, before you get too giddy thinking about hybrid investments, let’s go back to those value-add risks for a minute.
Risk in Value-Add Investments
Have you ever watched one of those fix-and-flip shows on HGTV? There isn’t a single show without drama.
They pulled up the flooring and found foundation issues. They struck a water main while in the midst of renovations. Unexpected storms / flooding / earthquakes / other natural disasters created setbacks in the timeline. You get the idea.
These are all risks that investors have to take into account when taking on a value-add project.
When you’re making changes to anything, there’s always the risk that something might not go according to plan.
Examples of Risk in Value-Add Investments
In multifamily value-add investments, common risks include:
- Not being able to achieve target rents
- More tenants moving out than expected
- Renovations running behind schedule
- Renovation costs exceeding initial estimates (which can be a big deal when you’re renovating hundreds of units)
When we evaluate deals to decide whether we want to invest in them ourselves, we’re always looking for sponsors who have capital preservation at the forefront. Their number one goal should be not to lose our initial capital investment and they should have a number of risk mitigation strategies in place, including:
- Conservative underwriting
- Proven business model (e.g., some units have already been upgraded and are achieving rent increases)
- Experienced team, particularly the project management team
- Multiple exit strategies
- The budget for renovations and capital expenditures is raised upfront, rather than through cash flow
Value-add investments are powerful vehicles of wealth. They come with serious potential upside, but along with that upside comes risk. That’s why we work hard with sponsors to put in as many risk mitigation strategies as possible, to ensure that we’re turning over every stone and protecting investor capital at all costs.
Recap and Conclusion
All in all, no investment is free of risk. However, we’re of the opinion that value-add investments, despite their potential risks, provide greater benefits to both the investors and the communities.
By leveraging investor capital in a value-add investment, we’re able to help drastically improve apartment communities, thereby creating cleaner and safer places to live and putting more smiles on tenants’ faces.
And because we can decide when and how to execute the renovations, we have more control over the investment, rather than relying solely on market appreciation, thereby creating more levers and options to safeguard our investment and maximize returns.
Value-add investments are a true win-win, which is one of the reasons we love them.
Until next time, Earn Passively & Live Abundantly!
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