Updated: Jan 9, 2021
Many passive investors who are looking at investment opportunities, often look to commercial and multifamily investment properties. But it’s a well-known fact that every type of commercial property comes with its own set of benefits and risks.
Approaching commercial real estate investments with the thought of “how much profit will I make” is not the proper approach. Instead, you need to answer the question of, “how much risk am I willing to take.” And even though you may consider yourself a “passive” investor, you still need to be a well-informed one. That includes educating yourself about multifamily investing, attending meetings and participating in calls with the syndicator. Most importantly, ask questions whenever you have any. Here is a more detailed look at how a passive investor should manage their investments.
So what is a value add deal?
Unlike a turnkey property, which usually has investment grade “class A”, which is a new building or a building that has been built in the past 10 years and that is in top condition, value add properties require improvements and other strategies to bring out their value. On the other hand, they also offer an opportunity for investors to make greater profits compared to turnkey investments. The reason that some properties are referred to as “turnkey investments” is because nothing really needs to be done to the property in terms of improvements.
Value add properties achieve greater value by either increasing income or by reducing and optimizing expenses. The investors involved in a value-add property often work to increase the cash flow as fast as possible, while keeping costs at a minimum. Value add properties are consistently attractive to multifamily property investors for obvious reasons.
Here are the three main tactics to increase the property’s income:
Tactic #1: Increasing rents
Part of the equation to increase income is achieved by increasing rents. To justify the increase, syndicators raise rents by improving the property. Often, the rents are below market rates, but improving the property is how most value add deals work, since syndicators need to justify the new rents, which they can do by renovating the property.
Improvements run the gamut from exterior renovation to upgrading the interiors and can cosmetic or heavy. Exterior renovation often includes exterior paint, renovating the clubhouse and the gym and resurface the parking lot. Interior renovation usually includes stainless steel appliances, granite countertops, decorative backsplashes, paint, new vinyl or hardwood floors, lighting packages and hardware. The cost per unit can run as low as $2,500 and as high as $9,000, with $6,000 being the average cost in many cases. The exterior and interior renovations and improvements help to attract higher quality tenants who are able to afford the increased rent.
Another strategy includes adding washers and dryers for tenants’ use, as it’s the number one amenity sought out by renters. The premium (rent increase) from washer and dryer in units ranges between $30-$45 a month.
An additional upgrade tactic is to offer storage units to tenants for additional fees. Even simple storage closets that can hold a bike and some boxes go for up to $30 per month on top of the monthly rent.
Tactic #2: Creating New Sources of Income (besides rents)
Another approach to increasing income is to generate other sources of income. This tactic includes adding amenities that the property lacks, such as a gym, package distribution center, covered or reserved parking, bike rack, a yoga room and other amenities that appeal to the current tenants.
Tactic #3: Applying RUBS
Another tactic to increase income is to implement a ratio utility billing system (“RUBS”) whereby the property owners bill back tenants for their utility usage based on the size of their unit and the number of occupants, rather than charging a fixed fee for all units. This not only helps to bring in more income, but also helps to reduce expenses as well.
Besides increasing rents, syndicator often increase their property’s value by reducing expenses. Here are the two main tactics to do it:
Tactic #1: Revisit Current Operation
Savvy syndicators scour the profit and loss (T-12) statements in order to thoroughly analyze current operations. A line-by-line analysis is the only way to find expenses that can be reduced, and every penny saved on expenses goes back into the income column.
One example is model units. Most properties have model units that prospective tenants can view. The problem is that these units are no longer available to rent, and that is lost revenue. Often, syndicators go in and eliminate several of the model units and place them back on the market.
Another line item is payroll, which is generally the highest expense after property tax. Successful syndicators use their knowledge and experience to determine the optimal number of employees needed to run the property successfully, and eliminate positions that are not needed.
Tactic #2: Replace Management
Another approach used by syndicators is to take a hard look at the property management company to determine if the property is managed efficiently. Many multifamily properties are operated at 42%-55% expense ratio, which means that expenses are between 42% to 55% of income. Formulas are used to determine the income to expense ratio, and often there is an opportunity to reduce expenses through proper management. When this happens, cash flow is increased and the value of the building increases as well.
Achieving success with a value add investment
It takes extensive market knowledge and strategic discipline to succeed at a implementing a value add plan. As a passive investor, you most likely don’t have the experience or knowledge to execute a value add deal, nor should you. By investing with an experience syndicator, you can let them manage the investment and run the
Appreciation – the other major benefit of a value add deal
Besides the obvious benefit of increased cash flow while investors own the property, the other major benefit of value add deals is appreciation. When it comes to multifamily properties, investors usually use Cap Rates to determine how much to pay for a property. Cap Rate calculated by dividing the purchase price by the net operation income (“NOI”). NOI is the income after expenses are paid (without taking into account loan payments and depreciation). If there are 2 identical buildings, in the exact same location and same number of units and condition, but one is generating higher income (or NOI), then it will be sold for a higher price than it’s lower NOI twin. Why? Because buyers will use the same cap rate to calculate the maximum price for both properties, and the one with a higher NOI will have a higher price.
By successfully implementing a value add plan, investors can maximize their chances to sell their property at the highest possible price.
The syndicator: the most important factor
If you’re going to be a passive investor, you have to place your trust (and your money) in the hands of a qualified syndicator. They bring knowledge to the table and do all the hard work putting the investment together. They’re the one who is scouring the country, looking for ideal multifamily properties to invest in. They’re the lead investor, and they make their money through fees.
They’re the one who will interact with the lender, and bring other passive investors on board. If ever there was someone to be vetted, it’s the syndicator. So be sure to do your due diligence before parting with any funds. Go to area meetups and real estate conferences where you can meet one-on-one with the potential syndicator. A face-to-face meeting is priceless when trying to get to know someone. You can learn more about finding a syndicator here.
Be sure to examine the syndicator’s track record, and look at some of the deals they’ve placed with other investors. What was the return? Were the projects successful? Was the syndicator able to obtain the loan quickly? The answers to these and other key questions will help to determine if the syndicator is someone you can invest with and feel confident that your money is in good hands.
Potential risks of value add deals
Regardless of the investment strategy being used, whether it’s turnkey or value add, there are bound to be some potential risks. It’s just the nature of investments, and it’s not limited to real estate investments either. Value add deals have several unique issues to beware of, and if properly managed, can have a minimal impact on the investment.
Because value add deals involve property upgrades and improvements, there’s going to be some type of construction involved. Whether it’s skinning the building into a new façade, upgrading a lobby or interior of the units, renovation work will be done on the property.
That means you may run into construction scheduling mishaps and cost overruns. On multifamily properties, some units may be vacant for periods of time while the renovation activity is carried out. This could impact the property’s cash flow, and it may take time to rectify the problem.
One way to mitigate those risks are to invest with an experienced syndicator, someone that has been implementing value add deals before, and did it successfully. The other way to mitigate the risks associated with a value add investment is to make sure that the property improvements are not being funded from the cash flow, but rather from a separate account with enough capital to cover all required improvements. Lastly, it’s imperative to mitigate the potential operating deficit by not removing too many units from the market at one time. Savvy syndicators who have experience in upgrading multifamily properties know how to balance the need to improve the property with the need to maintain proper cash flow and profitability. Just keep in mind that while there is some potential risks associated with value add deals, there is also a higher potential return as well, and risks can be mitigated if you choose your syndicator wisely.