Value-Add Multifamily Real Estate Investing

Today we're talking about value-add investing, specifically in multifamily properties.

Value-add is looking for opportunities to add value. You're going after appreciation. It's a strategy for investors that are in the growth phase that are looking to invest, time, resources, energy, capital, blood, sweat, and tears, to increase the value of a piece of real estate to a point that's higher. 

Value-add real estate is my favorite, because if you do it right, and if you're diligent and you're patient and you pick the right assets, you can get returns that are well above 20% to 25% IRR. I have clients that I have helped make 50% to 100% annually on their money in value-add deals. 

A great thing about value-add, and the reason that I like it is because you're cash flowing from day one. Value-add properties typically, not always, but typically are occupied.

I consider value-add to be different than a renovation. Renovation typically means an empty or vacant property. Value-add is just an opportunity to increase the income. 

Where does value come from? 

 Value comes from the NOI - Net Operating Income.

The NOI divided by the Cap Rate is how we determine value. 

Well, of those two factors, only one of them is within our control. And that's the NOI, it's not the Cap Rate. 

So the whole concept of value-add is increasing the NOI. 

How is Value Created?

How do you increase the NOI? There's two ways. You either increase the revenue or you decrease the expenses. We'll talk about both of these. 

And I actually have a blog post: "27 Ways to Add Value to Your Multifamily Property" and it's all about value-add tactics, even little incremental ones. 

So let's take a look at how the math works just from a high level. We're not going to we're not going to do any calculations, but I think it's important to understand how the value-add is achieved. 

Here's where it gets fun. 

In a 6% cap market, every unit that you bump $50 a month in their net operating income is $10,000 in value. Doesn't seem like that big of a deal, right? It's only $50. $50/month x 12 is $600 per year.

Imagine now you have a 30 unit building. $50 a month equals $300,000 in value.

Increasing Revenue

When we talk about opportunities to add value, what we're trying to do is we're trying to either increase the revenue or decrease expenses. 

 What are some opportunities for increasing revenue? Obviously the easiest way to increase our revenue is to raise rents. 

What are some other ways that we can increase revenue? We can have the residents pay for a portion of the expenses. We can do utility pass throughs or RUBS, ratio, utility billing systems.

We can create new sources of revenue: pet rent, parking rent, vending machines, appliance rental, laundry facilities on site.

Decreasing Expenses

But then another opportunity to boost our NOI is to decrease our expenses. We could have our property taxes reassessed if we think the property's overvalued. We could have insurance re-quoted. We can have a really good maintenance plan in place. We can get better management. We can change out the landscaping. We can reduce our utility expenses by installing low flow showers, sinks, and toilets to reduce the water bill. We can install LED lights in all of the common areas to reduce the electric bill. We could potentially even put it on a solar package. Value-add opportunities can come in many, many forms.

But one of the things that I really like about value-add is most of the time, there are at least some value-add opportunities that are management issues. 

I'll give you an example: vacancy. Imagine you have this property, and your vacancy is 10% twice what the market is. And then you go in and you look at why. If you could cut the turnover time in half, you cut your vacancy in half. Because vacancy is an economic number. It's how many days did the property sit not collecting any rent? That's value-add. 

Below market rents are just one attractive quality of an acquisition. They don't necessarily imply that there's a lot of value-add. 

Indicators of Value-Add Opportunities

Let's talk about signs that a property is a candidate for value-add strategy.

• Below market rents.
• Below market occupancy.
• Outdated interiors or amenities. 
• Deferred maintenance. And that would imply a need for capital improvements. 
• And the last one is poor management.
• For instance, I really like owner-managed apartments. Because if an owner is an owner operator, they're not typically incentivized to drive rents.

Owner operators are frequently doing a lot of the work themselves, and that means that every time a unit turns over, it creates more work for them. Owner operators usually don't want a lot of turnover, so they will often keep their rents low.

Consequently, their tenants will stay because as market rents go up, their rents have stayed the same. And they will stay there for a long time. A lot of the work and maintenance that's done on interiors is done during turnover. 

It's a compounding effect. You have an owner who's often friends with their tenants, which is a huge mistake, and they don't want to raise the rents because they don't wanna have to take on the effort and expense of having to turn the unit.

So they keep their rents low. And then over time, the building still incurs wear and tear. But because the property has not been bringing in enough cash, because the rents are below market, the expenses still will climb. And so over time, these expenses that are needed start to add up.

But the owner, because they've been keeping the rents low they haven't stockpiled enough reserves to do those improvements or to make those repairs. 

Have a Plan in Place Prior to Sourcing Debt

The lender's going to look and say what's the plan? What are some of the things that you can do? And so if a client is going to go after a value-add deal, they should have a plan in place and every plan is going to have costs associated with it.

 Let's just go through and talk about some of the really common ways to show the lender that you have a plan in place to achieve that. 

If you really want to put your best foot forward, you will do all of this before you talk to the lender, or you'll at least have some of these things quantified, analyzed or eliminated as a possibility before you submit your package to the lender.

The first thing is a market rent survey, right? And then doing any necessary rent increases. 

Improving the marketing and, sometimes that might involve rebranding the property. A lot of my clients will go in and if they're doing a heavy value-add they'll change the name of the building, especially if it's in maybe a class C area that might have a lot of crime or other issues, sometimes properties will get a bad reputation.

My very first acquisition was a 35-unit deal, and this was in a high crime neighborhood. It was a great value-add opportunity on paper. But this property had a terrible reputation. And the street that it was on was the border between two cities.

And our first weekend that we owned the property, we had a homicide in one of the units. And then when they called the police said, "That's not our jurisdiction. You need to call the other city." 

We called the other city. They said, "Nope. That's their jurisdiction."

Neither police department wanted to deal with this property. Bad reputation. And so rebranding can sometimes be very effective.

Improving the interiors. You can take a property that has old carpet and you couldn't put in vinyl plank flooring.

Appliances. Some of the biggest bang for your buck can come from appliances. A lot of times, properties that have room for a dishwasher, but don't have a dishwasher immediately can get a hundred dollar rent increase. A lot of people just won't even consider renting an apartment that doesn't have a dishwasher 

Putting in air conditioning. That can be a big one. 

We had a property that was perfect for a stackable washer and dryer. There was an extra closet. We were able to run some plumbing. We put in stackable washer and dryer. And at the same time we're implementing the RUBS the utility pass-thoughs, and we were able to boost our NOI by $150 a month per unit for something that cost us about $5,000 a unit to do. 

Exterior upgrades. Just making the building look nicer. 

Changing vendors. I always recommend owners look at the vendors that they're using their contracts, the pricing. And it's always important to keep vendors competing against each other. 

Purging the property of bad tenants. As much as I always go out of my way to do everything I can to avoid evicting someone. There are some tenants that need to go. And It is important. Bad tenants can poison the entire property. They can turn other residents against the management unnecessarily. They can create disturbances. They can obviously cause damage. Bad tenants need to be dealt with. And a lot of times, owner-managers will frequently make a mistake of being too tolerant of bad tenants. And what that does is it sets an example to the rest of the residents that they can behave poorly as well. 

The best value-add deal that I ever did was a property we bought for about $35,000 a unit. And it wasn't in terrible shape. But it was an owner-manager.

I was well versed in the area and I knew that the rents were way below market. The rents were almost 50% below market. I gave the seller everything they wanted and he just wanted out, he just wanted to retire. We went in, we put in new appliances and we put in decks outside. They had these tiny little, they weren't even real decks. They were just little landings. And we went and put on full on patio decks out there. 

Most of our residents, they knew that their rents were absurdly cheap. We actually kept most of them. And they were very excited because we didn't just go in and try and raise rents without giving them any value in return. That wouldn't be fair. But this is just an example of lot of different ways that you can create value.

Financing for Value-Add Properties 

How do lenders look at value add deals? The first thing is they want to know where the value-add opportunities are. And what are the causes of the NOI being substandard? 

They don't have enough debt service coverage. One of the drawbacks of investing in value-add is typically the sponsor or the investor has to come up with much more capital to put down and to implement those improvements so that they can raise the income. 

Most of the time the financing on a value-add deal is still going to be based on the net operating income. 

You might though get what's called an affordability discount. Some lenders offer an affordability discount if the rents are below market. They'll shave a quarter point or a half a point off the interest rate to allow the owner to capture a little bit more cash flow and implement whatever their plan is.

Also a great way to approach a value-add deal is with interest-only terms. 

Frequently, my value-add investors will say, "Okay, I'm going to get a five year loan. I'm going to get one, two or three years of interest-only payments." So that their payments are going to be significantly lower during that interest only period than they would be if the loan was amortizing.

They're not necessarily concerned about principal paydown because they're solely focused on raising the income. 

Realize the Value You Have Created

Another thing to think about when one is growing their portfolio, the most important thing is, after the NOI has been brought up, you've created appreciation, you can't actually benefit from that appreciation until you sell that property, take that appreciation and all of your equity back out and then redeploy it. 

You buy the property, you implement the value-add strategy, you sell the property, you calculate how much wealth you built, and you reinvest that.

Most of the time value-add is going to have a shorter holding period. Not always, but most of the time. You're frequently going to see newer investors pursuing a value-add strategy because they're the ones that are trying to build wealth and grow, more so than somebody who's already grown.

But people who really love value-add like me, I'll take on a value-add property most of the time over like a core property because I think it's fun. 

I think it's really interesting to take a building and make it better. 

I want the influence that I had as an investor to be better for the residents and to be better for the community. And it's not all about just raising rents. That's not the goal. The goal is not to burden the residents. 

A lot of savvy investors will do their value-add incrementally. So If they're doing any sort of work on an interior that's going to be disruptive to the tenants, like replacing the flooring or adding amenities, they'll do that on turnover.

So while the unit is vacant, they'll get the whole crew in there and they'll do all the improvements, and then they'll remarket that unit at the higher rent. So you haven't actually negatively impacted somebody who lives there. 

 Typically the loan is very straightforward. Just like any other loan. They're going to say, what's your NOI? What's our debt service coverage ratio. And they plug it in. And the difference between your financing and your sales price is how much you have to put down.

And then you have to also have the money to do your value-add. 

That's frequently where you will find people come up with a bridge loan or a mezz piece, or some sort of secondary financing, or they'll bring on a partner. They might have the seller carry a portion back. It's not as complicated as you might think. 

Get Financing with Evergreen Capital

If you're looking for financing for a real estate investment you are working on check out our website at Evergreen.LLC. 

Trevor Calton is the founder of Real Estate Finance Academy. Since 1997, he has analyzed, acquired, or sold more than $5 billion of commercial real estate assets, financed over 500 commercial investment properties, and overseen the asset management of over 6000 units of multifamily housing.

He has been teaching commercial real estate classes and training professionals since 2005. His commercial real estate classes and real estate finance development program helps people at all levels develop a successful real estate investment strategy.