Early in 2021, I added a feature in our Multifamily Value-Add Model that allows investors to delay the start of value-add implementation. Many investors were interested in executing value-add during Covid but were unsure it would be wise to do so with so many unknowns when initially facing the pandemic. There was trepidation amongst investors, and they asked for a more cautious approach to renovation projects.

The purpose of this article is to discuss real-life situations I've come across where it may make sense to delay the renovation until later in the investment hold.

Benefits of Delaying Multifamily Renovations

The most significant benefit of delaying a value-add implementation business plan is to yield a more conservative proforma analysis.

• Renovation capital still raised upfront (in Year 0)

• Delayed rental premiums

• Muted returns (most notably IRR and equity multiple)

The longer the value-add is delayed, the more return metrics will be affected adversely. This results from muted rental growth early in the proforma, which reduces net operating income (NOI) that will eventually be capped in the residual sale year.

Warning: Delaying a value-add too much at a multifamily property is risky. If you don't think a value-add is feasible in the imminent future, is the multifamily property truly value-add?

The Tactica value-add underwriting tool allows you to delay a renovation start from one to ten years upon purchase:

This feature is most appropriately utilized when the delay is one year or two years. Delaying renovation services beyond that is too much of a crapshoot, as the market could shift considerably beyond that.

Justifying Delayed Value-Add

Low Occupancy

A blip in occupancy may make a property renovation unfeasible in the short term. Renters in many urban areas nationwide moved out of the city and relocated to less densely populated regions in 2020/2021.

Property owners were bullish about residents returning to the city once a COVID-19 vaccine was widely distributed, and government shutdowns ceased. This trend is beginning to play out in 2022.

Properties primed for a renovation pre-2020 but faced a Covid vacancy spike that hindered operations and were perfect candidates for the delayed “Reno Start” feature. 

Generally speaking, I tend to shy away from a renovation strategy if occupancy dips below 90%. If resident retention is a struggle at the current rent levels, how could potential tenants justify higher rents?

High Unemployment

Good jobs support rent increases. It would be best to steer clear of bullish rental forecasts in submarkets where rampant unemployment is a trend. I feel so strongly about this; even if the property is 100% occupied, I'm still hesitant to bank on a value-add if the submarket labor statistics lack. 

In cities or counties that were heavily dependent on industries affected by COVID, this was likely a short-term blip, and the property was likely ripe for improvement projects once the employment market recovered.

Favorable Rent Comps (Almost)

Nothing screams value-add potential like comparable properties of a similar vintage that have undergone renovations and are advertising their units at $100+ for similar floorplans. 

What I've found, though, is that many of these comps with superior market rents can be offering tenants significant leasing concessions. It may be worth calling the property manager posing as an interested renter to see what incentives are offered. Concession levels may not be as apparent from online marketing alone.  

If most of the comps offer residents concessions, they are likely having occupancy issues. Perhaps in the short term, your best bet is to continue operating the property “as-is” and hold off on the cosmetic capital improvements.

Labor & Materials Shortages

In 2022, a significant source of strife for owners has been labor shortages and materials pricing skyrocketing. A value-add strategy may be formidable, but not right away. It may make sense to operate the property as-is until there is some pricing relief on the overall value-add scope.

Prudence

Maybe you want to “underpromise” with the hope of “overdelivering” on investors’ expectations. Explaining the delayed value-add to potential limited partners (LPs) may be appreciated by investors who prefer your proforma erring caution. It may distinguish you from other general partners (GPs) who are overly aggressive and unrealistic in their proformas. It will demonstrate your knowledge of the overall fundamentals affecting multifamily ownership and win over specific LPs, especially risk-averse ones.

We can see with a real example how the returns are affected when a renovation project starts in Year 3 vs. Year 1. All assumptions in the proforma are identical other than the renovation start date.

Scenario: 7-Year Investment Hold

Leveraged IRR starting the rehab in Year 1: 14.96%

Leveraged IRR starting the rehab in Year 3: 13.97%

The Year 3 “Reno Start” lost about 100 bps of IRR compared to a renovation commencing in Year 1. Most of this IRR discrepancy comes in the form of decreased residual NOI when selling the property in Year 7 due to less rent growth that has taken place.

Renovation Contingency

If you utilize the delayed value-add feature, I would also underwrite the building separately as if there were no value-add opportunities.

I think it's wise to model a scenario with no interior unit cosmetic capital or premiums but underwrite capital for:

• Common areas

• Landscaping

• Curb appeal

This way, if the subject property is struggling with high vacancy, job loss, submarket concessions, or inflation, you're at least being proactive in making an excellent first impression with potential residents touring your units. You can backfill expiring leases at the historical rental rates.

Delayed Renovation Summary

The value-add landscape has changed as we find ourselves in an inflationary environment and have the Fed fighting inflation with increasing interest rates and quantitative tightening. Modeling potential rental premiums should be done with discretion. The delayed renovation start is a great way to limit your downside and potentially protect your equity investment.