Real estate, specifically multifamily real estate, is an asset class that offers many different strategies to generate above-average returns. Here I will focus specifically on the value-add strategy applied to multifamily. This is the commercial counterpart to flipping or the BRRRR strategy found within the single-family space. Simply put, this strategy includes acquiring a property with a significant opportunity to increase its valuation to then be able to extract it either through a refinance or sale. Before we can delve any deeper, we must understand how multifamily properties are valued.
I. Valuation of Commercial Multifamily Real Estate
Unlike residential real estate (<5 units), commercial multifamily property values are not tied to comparables (comps) in the area. Instead, the value is directly tied to how much income the property produces. In fact, the value of a property can generally be calculated using the following formula:
Net Operating Income ÷ Capitalization Rate = Property Valuation
Let’s break this down piece by piece:
Net Operating Income (NOI) is the gross property income, from rent and other sources, minus the property’s operating expenses. Operating expenses may include landscaping, waste, water, property management, insurance, repairs/maintenance, and more. Note that operating expenses do not include debt service as this is different for every operator and is a financing expense.
The Capitalization Rate (cap rate) is a reflection of what investors are willing to pay for the NOI that the property generates in that specific market. In other words, the cap rate is essentially a gauge of how desirable a certain asset class is in the market in which it is located.
Example:
Assume recent sales showed that stabilized class A properties in the Denver, CO market were selling for cap rates around 4%. This would mean that you could comfortably value a class A multifamily property that produced an NOI of $200,000 at about $5,000,000 ($200,000 ÷ .04 = $5,000,000).
Cap rates vary across markets and asset classes, among other things.
Example:
It wouldn’t be unlikely for class C properties also in the Denver, CO market to be trading at around a 5% cap rate. This is because higher perceived risk is reflected in higher cap rates, which drive the value of a property down. In this scenario, a class C property in Denver that was generating the same $200,000 in NOI would only be worth around $4,000,000 ($200,000 ÷ .05 = $4,000,000), this makes sense as Class C properties are generally perceived as riskier than class A properties.
II. Adding Value
As a reminder:
Net Operating Income ÷ Capitalization Rate = Property Valuation
It is important to understand that the cap rate is ultimately determined by the market and there is little we as operators can do to change it in any meaningful way. Therefore, if we want to increase the valuation of a multifamily property, we must focus on the NOI. If NOI equals Income – Operating Expenses, the NOI can be increased by increasing income and/or decreasing expenses.
A. Increasing Income
When identifying value-add opportunities, you will want to look at what the market shows tenants are willing to pay for. Examples include any of the following:
– Amenities
– Rebranding
– Better property management
– Upgrades (interior and exterior)
– Security
When looking at properties that may have been mismanaged in the past, you will likely see some great value-add opportunities in the form of higher-than-average vacancy – which can be fixed through strategies listed above – as well as loss to lease (LTL). LTL occurs when scheduled rents of a property are less than what the market says they should be. This is common among properties without the most efficient property management and even more so among mom-and-pop operators. LTL is one of the best things to look out for as it can usually be a quick and non-capital-intensive value-add opportunity with huge upside-translating to disproportionate returns for investors and operators.
It is also important to look for ways to add streams of revenue. Common examples would be covered parking spaces, storage, and garages. The additional revenue is often well worth the capital needed to implement these.
Example:
Let’s say that Foxland Apartments is a 100-unit complex in Hendersonville, TN. The average rent per unit per month is currently $1,500. As a prospective buyer, you conduct market research and find that the average market rent for comps with similar square footage and bedroom counts is $1,650 and the only difference is these properties have a swimming pool and dog park accessible by the tenants. You also know that similar assets are trading at a 5% cap rate in the area. This means that you could increase the NOI by $150 per unit per month-adding $180,000 to the NOI ($150 x 100 units x 12 months = $180,000). Dividing this number by the 5% cap rate would equal $3,600,000 in value added to the property. If these amenities cost you $250,000 to add, then you have achieved a 1,440% return on that capital.
B. Decreasing Expenses
Just as increasing income directly affects NOI, so does decreasing expenses. Finding ways to manage expenses is another activity that is usually not capital-intensive and can add massive value to the back end of a property. When underwriting poorly managed properties, you will likely come across outlandish numbers for some expense categories. These should jump out to you as gold mines. You might find that the operator has been overpaying for landscaping by about 150% because they use their buddy’s landscaping company. Or you might find that the water bill is about 25% more than your similar-sized property across the street because the toilets and plumbing fixtures are outdated and inefficient. Below is a list of common operating expenses for a multifamily property.
– Payroll
– Property Insurance
– Property Taxes
– Utilities & Trash
– Property Management
– General & Admin
– Marketing
– Contract Services
– Repairs & Maintenance
Finding inefficiencies when underwriting expenses should be incredibly exciting as a value-add investor.
Note: When looking for ways to decrease expenses, do NOT do so with insurance. You will want to be properly insured as you likely have investors behind you who are depending on you to perform and provide expected returns. Insurance ensures that something unexpected does not blow up your deal and is essential to the success of any deal.
III. Exit Strategies
After adding significant value to a property, you may find yourself ready to pull that equity out. Whether it be to pay investors back or to redeploy that capital elsewhere. This usually happens in one of two ways:
A. Sale
Many operators will opt to sell an asset directly after the value-add stage to capture all added value to be able to make final distributions to investors on the deal and potentially be able to redeploy the capital into another deal and do it all over again. However, if you are more of a long-term investor and do not necessarily want to completely exit out of a deal, you can refinance.
B. Refinance
Refinancing allows investors to pull most of the added equity out of a deal to pay back investors or redeploy capital, all while still maintaining ownership of the property and benefiting from the likely large cash flow the stabilized asset is providing. A potential drawback would be the limited amount a lender might be willing to refinance, common numbers are 65-70% loan to Value (LTV). However, with the right value-add deal, this could still be more than enough to pay back all investors and still have a sizable amount for all operators involved.
IV. Benefits
As you can see, value-add investing in multifamily assets provides disproportionate returns compared to other avenues of investing inside or out of real estate. This is simply because of the number of ways to increase the valuation of a property immensely with relatively little capital. At a 5% cap rate, every $100 of monthly NOI equals $24,000 of value. This is why this strategy is a highly sought-after avenue for both operators and passive investors. Depending on how the deal is structured, it is not uncommon for passive investors to achieve an internal rate of return (IRR) of over 18%, with an exit in 3-5 years. Where else can you find returns like that? I’ll wait.
V. Risks
As with anything, one must understand the risks involved. It is very important to know exactly what you may be getting into when looking at a potential property. Most, not all, risk can be mitigated with superb underwriting. You will want to understand every aspect of the current income, current expenses, projected income, and projected expenses. You will want to conservatively underwrite terms for debt-structure both current and future-if you plan on refinancing. You will want to be very conservative when projecting future cap rates at the time of exit as this will drastically affect your valuation. You will want to make sure you have a good idea of how much work the property will require and the exact costs associated with said work. It is always better to be conservative when underwriting real estate deals, especially when investor capital is at stake. Luckily, multifamily real estate is a very forgiving asset class. Risk can be mitigated-not eliminated-through thorough education and by having the proper team in place. This is very much a team sport and going at it alone can be a huge mistake. By leveraging experience team members and ensuring proper education and underwriting, you can ensure minimal risk and maximum returns.
Thank you for reading and be sure to share if you found this valuable!
Dream Bigger,
Jaden George
