Updated: Apr 23, 2020
Commercial multifamily investments are as much an investment as they are a business. When investing in a value-add property, you are investing not only in the property itself, but in the ability of the general partnership to achieve their goals. Goals come in the form of returns to investors and returns to investors are achieved by implementation of the business plan. This article will touch on some of the ways we add value to our properties, and provide an example of how this added value translates into dollars and cents through the cap rate formula.
When looking at commercial multifamily assets, we see an array of property types classified generally by what market they serve, where in the life cycle the property falls and the amount of leverage used. Core, Core-Plus, Value-Add and Distressed/Opportunistic are 4 types of asset classes within commercial multifamily.
Core properties are low-leverage, low-risk/low-potential return assets with predictable cash flows. They are generally stable, fully leased, typically class A properties located within strong, diversified metropolitan areas, often in gateway cities. Leverage for core strategies typically lies in the 0% to 30% range.
Core-Plus often is confused with and/or mistaken for value added real estate investment strategies. The term "core plus" was originally defined as "core" plus leverage, or leveraged core. Leverage for core plus strategies typically lies in the 30% to 50% range.
Value-Add properties are considered value added when they exhibit management or operational problems, require physical improvement, and/or suffer from capital constraints. Leverage for value-add strategies typically lies in the 40% to 80% range.
Distressed/Opportunity property investment strategies are high-risk/high-return. The properties will require a high degree of enhancement. This strategy may also involve investments in development, raw land, and niche property sectors. Leverage for distressed properties is typically 60% and higher.
Business Plan Components
When evaluating a property for its potential, as a value-add real estate firm we seek opportunities to improve the property. This can be in the form of physical improvements and/or operational or financial improvements. Some examples of physical improvements are:
Enhanced or Additional Amenities
One of the main things tenants care about and are willing to pay a 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 least desirable either. We strive for a good spot in the middle.
Popular apartment renovation plans include 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 sub-market trends and apply that knowledge to your plan.
The typical process for a large scale interior renovation program is first a market study of comparable properties in the area. We identify what interior renovations are commonplace and what type of rent premiums they're getting in the market. After we’ve acquired the new property, we will immediately notify the tenants of our plan to improve the property’s units and subsequently what rent increase they can expect. You would be surprised by how many tenants choose to pay the increased rent and do not wish to move. Tenants are presented with a new lease and have to option to vacate. This process is rolled out in blocks of units rather than all at once. As tenants organically move out, the units are renovated and marketed to new tenants. The process continues until all the units have been renovated and rental premiums achieved for our investors.
New commercial multifamily communities are chock full of amenities that reflect a changing cultural perspective of commercial multifamily. To compete with other properties and be able to achieve higher rental premiums, it is necessary to both improve existing amenities and add additional amenities.
The right amenity carries the potential to open up entire new market segments to our properties.
For example, a fully equipped business center with conference rooms, high-end office equipment and even reservable office space will attract young professionals who do not see themselves purchasing a condo or home.
Value-add properties usually require some level of improvement to the core functionality of the property. While these improvements don’t necessarily add a rental premium to new and existing leases, they are mandatory for the future viability of the building and will impact cash flow. During the due diligence phase of the acquisition, these infrastructure components such as the plumbing, HVAC and electrical systems will be evaluated for repair or replacement. While the immediate results may not be reflected in rent premiums, they most definitely will be reflected in the future sales price. So it is important to identify areas where value can be added to the core physical structure as future institutional and private buyers will evaluate core functionality.
Aside from physical improvements, there exists another area where a commercial multifamily investor can add value. Improving the operational profile of a property is key to increasing the value and future sales price of a property.
The leasing office is a great place to start.
When leasing agents aren’t rewarded based on performance, there is no incentive to improve the property's operations.
Implementing programs that reflect alignment of interest is critical to ensuring tenant quality remains high and rent premiums are realized. Tying a leasing agent’s compensation to occupancy rate, economic occupancy rate, new leases, turnover time, lease terms and rent is a great way to ensure the property management team is working with you and not against you. These are some of the strategies we utilize to ensure operational efficiencies.
So how exactly do these improvements translate to returns for our investors? There is a well known formula that commercial multifamily properties, brokers and owners follow for valuation:
Value = Net Operating Income / Cap Rate
Value is essentially the sales price.
Net Operating Income is the yearly profitability of the property.
Cap Rate is Capitalization Rate and indicates the property’s intrinsic, natural, and un-leveraged rate of return. Cap Rates vary by market and sub-market.
To continue with our example, take a 400 unit property where we have identified a multitude of value add opportunities to improve the property. Upon implementation of this business plan, we can expect rental premium increases of $150 per unit. So what kind of impact can we expect this business plan to have on the bottom line: How much more can we sell it for?
Assuming a market with a 6% Cap Rate, the property’s value would increase by $1,000,000 (400 x 150 / .06). So by implementing changes to achieve that $150 rent increase, investors can expect to receive almost $1M in additional profit upon sale.
A value-add commercial multifamily investment is only as good as its business plan. When selecting a property for acquisition, we focus on an asset class that we believe has the highest returns relative to how much risk we are assuming in the deal. Interior renovation, adding amenities, and improving infrastructure components are some ways we add value to a property. Aligning operations with the interests of investors ensures property management efforts are reflected in Net Operating Income. Small changes in rent premiums translate to big value increases when it comes time to sell.
Invest with fyre CAPITAL
fyre CAPITAL is a commercial multifamily investment firm. We purchase and/or partner in 150-600 unit, value-add apartment communities in fast-growing Tier 1 & 2 U.S. markets. Together with our strategic partners, fyre CAPITAL represents over 500 Million Dollars of successful real estate acquisitions. Our developers, sponsors and capital partners have amassed a network of over 1,500 unique investors. We provide new opportunities to invest in projects targeting a 14%-21% Internal Rate of Return . If you would like to join us on our next project, your first step is to Submit an Interest Card. We look forward to partnering with you.