Multifamily Renovation: Planning a Deeper Value-Add
Multifamily Value-Add—It has been an ordinary piece of lingo flying around the real estate world for over a decade. It has been a wildly successful apartment investment strategy that centers around buying apartment properties, renovating the units, and increasing the rent.
This has been the preferred business plan for many multifamily investors during the current cycle. It's been so commonplace that finding a property that has been untouched cosmetically since being constructed in specific markets is nearly impossible.
Multifamily Renovation Contents
Most properties coming up for sale have already undergone apartment renovation projects. As an investor, you must determine if there is potential for more. Typically, an older apartment property will be one of three things:
Untouched
Partially Renovated
Fully Renovated
I describe the three statuses and how each should be perceived.
Untouched: You likely found a great opportunity primed for capital investment and rental upside. The only time this isn't the case is if the property is in a location with comparable properties nearby that could justify rental upside improved finish levels.
Partially Renovated: You must decide if you will continue implementing the current owner's rehab plan on the remaining units. If you think there is potential for a "deeper" value-add (better improvements), will you implement it on only the remaining untouched units? Or across all units, including the ones that have been worked on recently?
Fully Renovated: You need to decide if it is worth revisiting the units and adding new/better improvements. You'd be surprised at how often there is some upside, even when a new property is marketed as "renovated" and "turnkey."
The partially renovated property is the trickiest to plan for. It's easy to comprehend the state of the property, but thinking through the actual logistics of phasing in an apartment renovation involving different costs and rehab plans on different units can be daunting.
The complications can amplify when old ownership implemented three or four different remodeling scopes over the years. I've had to work on them! It can be messy.
This article aims to teach you how to organize this data in a way that can be interpreted with ease and help you develop a bankable value-add business plan for the units upon taking over ownership.
Reliable information about the current state of the property is critical.
The property management company that is overseeing the property will need to provide you with a rent roll that shows the following:
Units (obviously)
Floor plan of each unit
Square footage of each unit
Rent of each unit
Updates that have been implemented in each unit
Value-Add Proforma
Occasionally, you may look at a multifamily property mismanaged to the point where no records exist. The manager may say, "Oh, we've been doing some rehabs, but it's been random, and we don't have them on file." If so, you must take detailed notes or pictures when touring. While this is annoying, rest assured, this is likely a phenomenal opportunity.
Once you know which units they have renovated and what those updates include, brainstorming the business plan will be the next step.
The most critical assumptions when formulating your value-add underwriting plan are:
What updates are needed?
What is the cost of these updates?
What rental premium can they generate?
If you are considering installing hard surfaces, stainless steel appliances, and upgrading common area carpet and lighting, find comps that have done the same and see what they are getting in rent.
For me, a comparable property:
It was built in the same decade
Has similar amenities
It is in a similar location
I frequently look at the new construction in the sub-market, too. Usually, this will provide great ideas for improvements. Typically, you can mimic the features of these new developments in an older property. This strategy can create a compelling argument for budget-conscious renters to rent your unit with "new up-to-date features" at a fraction of the cost. This will only work if there is a significant difference in your unit's cost versus the newer competition.
For example:
"You can live at the new property and pay $2,000, or at this freshly renovated property with many of the same in-unit amenities for $1,350."
Whether you are competing with other properties that have undergone apartment remodeling or newer products in the sub-market, never assume that the renovated subject property will be able to fetch higher rents. Always make sure you can back it up. If you can't, you are effectively just guessing.
Note: Budget appropriate capital to improve the property's curb appeal. Every prospective renter will first see the apartment community from the outside. You don't want to sour their first impression of the property before they start touring a unit.
Sometimes, obsolete project components will likely deter the maximum rents you can achieve upon completion of the rehab scope. Some examples include:
8-foot ceilings
Lack of underground parking
Floorplans from a different era
Lack of communal amenity space
One of the biggest blunders I see investors make is thinking they can comp a value-add strategy off new construction. However, if the value-add property has 8-foot ceilings, lacks underground parking, offers limited closet space, and has a closed-off floorplan, it won't be easy to achieve the rents of the new construction.
Even if you match the finish levels, there’s no feasible way to increase ceiling height to 9 feet. The vintage units will feel smaller and more claustrophobic than the new project, with lofted ceilings and floor-to-ceiling windows. You’ll never be able to match the convenience of offering residents warm, secured parking. While you may be able to move or remove some walls to open up the vintage unit, it will never feel as open as the newly constructed project you’re comping/competing against.
Once you make the big-picture plan, it is time to get more detailed. These details include:
The cost of the new updates for each floor plan (for both vintage and previously renovated units)
How many years will it take to renovate all the units (how many can you finish each month?)
How long will the units be vacant while renovating them? One month? Two months?
The average return on cost (return on investment) for the apartment renovation plan
These bullets will be different depending on what the strategy is. Let's look at XYZ Apartments as an example.
XYZ Apartments consisted of 85 market-rate apartment units and was constructed in 1970. The current ownership group has renovated 30 units thus far. Improvements in those units include:
New Cabinets
Black Appliances
Laminate Flooring
Lighting Fixtures
Plumbing Fixtures (energy-efficient)
The unit mix at the property, organized by remodel status ("R" means previously renovated), is the following:
Once the property’s rent roll is inputted, broken down, and understood, decisions must be made on how the business plan will progress. It is crucial to have a firm understanding of where the property sits within its respective comp set to create a feasible and bankable strategy.
Let’s look at a few different scenarios that might play out.
In this example, the potential is to add improvements and enhance the 30 units the current ownership group has already rehabbed. The improvement plan will include some of the past enhancements, such as cabinets, flooring, lighting fixtures, and plumbing fixtures, but also include:
Granite countertops
Stainless Steel Appliances
Tile back-splashes
Minor tweaks to hardware/lighting
Adding these features should lead to a higher rent premium than what units currently achieve. These new and improved updates are often referred to in the investment community as:
Phase II value-add
2nd generation value-add
Deeper value-add
A deeper dive
All terms are interchangeable but mean the same thing.
There will be cost savings by not altering the cabinets, flooring, or plumbing fixtures in the 30 previously renovated units. It’s estimated that units will be held vacant for one month during the remodel, and it will take three years to renovate all 85 units.
The Premiums used in the proforma and the capital spend per unit are summarized below:
Notice that the capital spent on the previously renovated units is less. The cabinets, flooring, and plumbing fixtures are already done, so those units have significant cost savings.
By researching the comp set, you will be able to determine what the premium is. In this case, it’s an extra $100 on top of the previously renovated units. How about the original units? How were those premiums determined?
I backed into them. I looked at the targeted rent for each floor-plan once the phase II apartment renovations were implemented. I then plugged in a premium for the original units that would catch them up to that targeted rent level. For the One BR floor plan, this rent is $1,175, which is $150 over the current average rent of original One BR units.
If you think about it, this makes sense. The original units will require more work, cost more to renovate, and achieve a higher premium, but shouldn’t exceed the rent of its previously renovated counterpart.
Maybe you want to continue along with the old owner’s business plan. The key is making sure they are maximizing their premiums. You can use the premiums they already achieve at the property if they are.
For example, the $50 premium for the One BR is taking the average One BR R rent – One BR original rent.
$1,075 - $1,025 = $50
I think an average blended premium of $36 across the unit mix is way too low. If there wasn’t more upside at this property, I don’t know that it would make sense to continue with this business plan. The reward is not worth the risk.
Sometimes, an owner is just undervaluing what their apartment remodeling plan should achieve in rent. In the example above, a $36 blended premium is too low. Let’s pretend you will continue with their plan but charge significantly more.
Your targeted renovation rents will jump well beyond the rents of the already renovated units. For example, the Two BR/Two BA will achieve $1,261 + $200 = $1,461.
The current owner’s Two BR/Two BA R with the same renovations is only $1,300. You don’t plan on doing more work on the 30 renovated units, but in theory, this floor plan should fetch $1,461.
Thankfully, the value-add model has an “organic rent growth” toggle.
You can see above that I grew the $1,300 “Two BR/ Two BA ‘R’” rent by 6% over two years to catch it up to the targeted $1,461.
$1,300 *1.06*1.06 = $1,461
In real life, you would need to wait for leases to expire to increase them, so always play it safe and assume that it takes at least two years to catch up with the under-rented units. A one-year catch-up isn’t realistic.
Related: You should always stress your renovation plan and conceptualize the best and worst-case scenarios.
When underwriting value-add of any kind, it's essential that you realize the rent growth comes from two different places.
The rental premiums
Organically-which would happen regardless of the value-add (I refer to this as “baseline rent growth”)
The model I use allows you to control both variables. You enter the premium and can also control the baseline rent growth, as seen in the 6% example above. All floor plans can be increased (or decreased) by whatever escalator you feel is appropriate. The premium will then be phased in on top of that.
Eventually, this unit-specific data “rolls up” into an annualized proforma like the one below.
The renovation premiums are paid in arrears from an underwriting perspective because it takes time for the upside to hit the financials. Think of buying a property and instantly renovating one unit the day you take over. Assuming one month to renovate and rent out, you would only see 91.67% of the total premium upside (or 11 out of 12 months) during Year 1. The following month, you would only benefit from 10 months of premium out of 12 months. In the last month of the year, you would renovate a unit and wouldn’t see any upside until next year.
Rent growth is only 4.95% in Year 1, then jumps to 6.34% in Year 2. There is less in Year 1 because this delay in unit renovation premiums hit the financials. Year 4 is still 4.17%, even though the multifamily renovation is done by Year 3. Again, this is the effect of the premiums hitting the financials in arrears. The phenomenon causes an increase in rent growth one year after the rehab is complete.
The renovation vacancy and capital costs all tie into the assumptions made earlier for the duration that units will sit vacant during remodeling and the capital cost by floor plan.
Summarizing the Value-Add Renovation Analysis
As older properties continue to trade hands, you must create a business plan for a property that has already undergone some unit renovations. You should understand how to organize this data and possess the tools that will allow you to model multiple permutations of potential value-add scenarios that are accurate and reliable. If you need an instrument that can handle even the most complicated unit mix, check our Multifamily Value-Add Model.