Updated: Jan 9, 2021
Passive investors know that there are two ways to generate income from a multifamily property investment: the first one is net operating income, or “NOI” (which is the income you have left from rent and additional fees after you deduct all expenses, but before you paid the debt on the property). The second one is property appreciation. For most, property appreciation is the “icing on the cake,” because investors enjoy appreciation when the property is ultimately sold.
Experienced investors tend to buy value-add deals, because those deals offer more potential appreciation than a core property - one that is in excellent condition and doesn’t require any upgrades or repairs. And for properties that undergo a full renovation plan, there is even more potential for appreciation.
Start with an Underperforming Asset
The best properties for value add are those that are underperforming. Their rents are below the average market rents their competitors charge, or perhaps they have above average vacancy rates. Some additional sources of revenues are overlooked, from laundry facilities to reserved parking, for example. Perhaps there has been poor property management in place, which operates the property at a much higher budget than needed. Whatever the reason, the property is underperforming.
Another strategic approach is to look for Class-C properties that are located in B areas and can be repositioned to a Class-B property. The results would be the ability to attract a better class of tenants as well as higher rents. This would be the ideal repositioning strategy. There is one caveat, however: don’t expect a Class-C property built in the 1960’s to be easily repositioned into a Class-B multifamily property - especially if it’s located in a Class-C area. It is possible, however, takes a lot of time and money to do so. I personally prefer light to moderate renovation over a full repositioning, since it is much less risky strategy. Also, be aware that a major repositioning may require relocating tenants while work is underway. These costs can be significant, so be sure you know what the costs involved will be and how long the project will take to complete.
Conduct A Market Analysis
The cornerstone of any repositioning attempt is to do a comprehensive market analysis of all comparable units within a 3-mile radius of the property. This will provide a good overview of rent potential in the competitive areas. A good comp is one that has similar vintage (is 5 years older or younger than the subject property), has similar size category (has more or less similar unit count. You cannot compare a 20-unit building to a 200-unit building, but 100-unit can be compared to a 200-unit building), and similar amenities. Generally speaking, you want to compare assets that share the same class and in proximity to one another. It’s also a good idea to view competitors’ websites or visit the properties to see their curb appeal. We use Yardi Matrix, but there are many other paid services that provide that information, such as CoStar and the affordable reonomy. Craigslist is another source of comparable rents in the market.
Analyze Prior Marketing Efforts
Another approach to consider is to conduct a comprehensive review of the property’s past marketing efforts. One of the reasons that the property’s vacancy rate is excessively high could be due to poor marketing. Does the property have a website, and is it easy to navigate? Does it showcase the property properly, and entice potential renters to visit? If not, consider revamping the website, but wait until upgrades are made so there will be new photos to show. Also inquire where the property is being advertised. Apartments.com is a major website renters use, so make sure to look there as well.
Implement Ratio Utility Back Billing (“RUBS”)
Many owners and property management companies utilize ratio utility billing, which enables them to bill tenants a portion of the utility expenses on the property. It’s often called “RUBS” - for ratio utility billing system. The utilities can include water, garbage, electric and sewer. It’s an equitable system, and is often based on either the amount of square footage the tenant has or the number of people living in the unit.
Before implementing a RUBS system, it would make sense to check to see if the competition is also using the system. The reason being that some tenants may object if no other complex is doing it, and you could end up losing tenants. Many owners or management companies bill a set fee for the utilities, but it’s often a figure that doesn’t recoup the entire amount spent on utilities, but is one that is fair enough to get back some of the expenses.
What kind of numbers are involved? If you have 150 units, for example, and you’re charging $30 per month as a set fee that represents $54,000 in revenue each year. It also means that the NOI increased by $54,000, and the value of the property increased as well. It’s a significant amount of money that is worth exploring. Anytime you can pass on expenses to the tenants you’re lowering your own expenses and increasing revenues.
This also helps to force appreciation while increasing the property’s value. It’s really significant if you look at the figures: as an example, a $20 per month increase in income or expense reduction multiplied by 100 units would increase your income by $2,000. With a 10% CAP rate (capitalization rate), the value of the property would increase by $240,000.
Determining your Value Add Strategy
Ok, you’re ready to begin the renovation. But where do you start? Should you consider cosmetic enhancements, structural changes or operational ones? Each approach has its own pros and cons, and each has unique costs involved.
One of the main thing tenants care about and are willing to pay premium for, is a nicer apartment. When we look at a property and consider improving the interiors, we first conduct a market survey and understand what competitors are offering. We don’t want to be the nicest property, and of course, not the ugliest. We strive for a good spot in the middle. Popular apartment renovation plan includes stainless steel appliances (or black appliances, depends on the market and what competitors are offering), granite counter tops (or just resurfacing), new or painted cabinet doors, backsplash faux wood floor, 2-inch blinds, and 2 tone paint. Make sure you understand the submarket trends and apply that knowledge to your plan.
Rather than trying to do the renovation all at once, many investors choose to wait for apartments to vacate before making upgrades in order to avoid having to relocate tenants to another unit. Natural turnover will dictate how long it will take to make the improvements.
Keep in mind that upgrading units should be at the heart of any value-add strategy, because it often leads to the higher returns on the money spent on the project. As a general rule, investors should be targeting approximately a 25% to 30% return on investment for interior cosmetic renovations.
Adding or upgrading amenities play a big role in any vale add plan. Pool furniture, dog park, pet yards, reserved parking, car ports, gym – all are ideas we consider to either add or renovate whenever I walk a property.
Correcting problems with functional obsolescence like plumbing or HVAC systems are costly, but necessary. Cosmetic enhancements can provide a fresh-looking property with better curb appeal. This would include new landscaping, painting, rebranding and adding new signage. Cosmetic changes are probably the easiest and least expensive changes you can make. In addition, cosmetic changes can help to boost rents, but not as much as upgrades to units will do. Plus, they will not have a major impact on the building’s overall appreciation. However, there are some simple things that can be done that don’t cost a lot of money.
Operational changes can run the gamut from replacing current management companies or evicting tenants that are troublesome to others. They can also may include targeting a different type of tenant that has more disposable income, for not only higher rents but also for new revenue opportunities like reserved parking, washer and dryer rental in the units and other upgrades. We always look at how we can better operate properties that are mismanaged and have above average expenses, due to lack of experience or attention from the property owner.
What to Be Aware Of
As with any substantial undertaking on a property, there are some pitfalls to avoid. By planning ahead, you can avoid the negatives and end up with a property that not only generates higher NOI, but one that appreciates substantially as well.
One major point to avoid is the tendency to “over improve” the property. If you have a Class-C property that is attracting tenants that are comfortable with the building the way it is, don’t try to improve the units to something that a Class-A tenant would prefer. I walked a B property once and witnessed how the owners put down $20K to renovate each unit. The apartments were stunning, but nobody was willing to pay the high rents they wants to charge. It was way too nice for the area and for that specific property.
Another issue to avoid is making erroneous assumptions on how much you’ll be able to raise your rents. Make sure your competitive analysis shows what the competition’s rentals are priced, and analyze the return on your inv