Value-add properties offering revenue and value enhancement potential remain extremely popular among multifamily investors. According to Real Capital Analytics, value-add multifamily sales totaled approximately $5 billion, or 13 percent, of national apartment sale revenues during the first quarter of 2016. Value-add investors seek to generate heightened yields by harvesting untapped revenue potential or creating value through property upgrades.
Although the premise has been around for ages, value-add investment is sweeping the multifamily markets. This national trend reflects the thriving U.S. multifamily environment, where the number of residents willing to pay higher rents for an improved living experience is surprisingly deep.
In fact, statistics published by RealPage/MPF Research report that U.S. apartment rents grew 4.6 percent and occupancy rates averaged 96.2 percent during the second quarter of 2016.
Value-add investment blends art and science. Success requires creativity to uncover an asset's hidden potential and strategic discipline to execute an enhancement program that maximizes results. While the range of opportunities to create value in multifamily properties is broad, varying by property and market, they comprise three categories: operational enhancements, capital improvements, and total repositioning.
Operational enhancement opportunities are most common in under-managed properties and frequently require little capital investment. Examples include raising rents to market levels, initiating or enforcing fee income policies, such as pet fees and late fees, and reducing expenses.
Capital improvements designed to enhance the desirability and revenue potential of a property take many forms, but interior upgrades are the most common and measurable. For example, kitchen and bathroom upgrades breathe new life into older vintage apartments.
Total repositioning refers to the elevation of a community's marketability to appeal to significantly more affluent residents. It typically combines operational enhancements and extensive capital improvements.
Former affordable properties with expiring Land Use Restriction Agreements are another example of total repositioning candidates. When an affordable property's LURA expires, rent restrictions are either gradually phased-out or extinguished entirely, enabling owners to increase rents to market levels. Since affordable-to-market rent increases can be dramatic, they commonly trigger broad resident turnover resulting in a higher-income clientele and an improved property identity.
Since investors are as distinctive as the properties they pursue, it is logical that their underwriting criteria for value-add opportunities varies as well. Many, predominately private, owners find value-add success operating purely on instinct.
Other operators take a more sophisticated approach, particularly if they have institutional capital partners. The underwriting metrics applied by these investors are remarkably consistent.
For shorter-term holding periods of three-to-five years, the value-add investors surveyed by CapasGroup Realty Advisors target a leveraged internal rate of return ranging from 16 to 20 percent. The desired return on investment for capital expenditures usually centers on 22 to 25 percent.
For instance, unit upgrades costing $6,000 per unit must generate rent premiums averaging $110 per month to satisfy a 22-percent ROI threshold. That is, $110 x 12 months = $1,320 rent premium / $6,000 investment = 22 percent return. Although return requirements and upgrade costs vary by investor and property, these concepts apply to most value-add scenarios.
Strategies for Success
The most critical strategic consideration for value-add investors relates to the scope of their property enhancement programs. Successful value-add strategies strike the optimal balance of cost-versus-reward, measured by ROI. Underinvesting in upgrades can leave potential revenue on the table, while overspending on improvements that do not materially increase revenue can dilute returns.
Strategic planning for value-add investments must also recognize the crucial role reversion pricing has in achieving investors' IRR objectives. Balance is required to achieve the optimal combination of revenue enhancement and reversion price. For instance, while upgrading 100 percent of the units might maximize potential revenues, doing so may completely exhaust the asset's upside potential thereby inhibiting its marketability at reversion.
Recognizing that the most likely purchaser at time of reversion will evaluate the property based on its future upside potential, experienced value-add sellers frequently limit the scope of their improvement programs. This strategy is designed to give future buyers the ability to create additional value, ensuring the seller's ability to exit the investment at an acceptable price.
Value-add investment is an intriguing, timeless concept. As long as properties age and market conditions change, opportunities to harvest new revenue and drive value will continue. The current environment of rapid rent growth and low interest rates has benefitted value-add investors. Going forward, as rent growth stabilizes and interest rates increase, value-add success will become increasingly dependent on investors' market awareness, ability to adapt, and adherence to a disciplined strategic plan.