Updated: Dec 1, 2022
There are three types of investments when referring to apartments. The three types are distressed, value-add, and turnkey. Each investment type has its perks and drawbacks.
Turnkey investments do not require major repairs and run well immediately upon purchase. These investments are low risk and have consistent distributions but due to that, they offer low returns.
Distressed investments require major repair and renovation. These properties may be uninhabitable or have extremely low occupancy. Distressed properties are high risk and there may be no distributions until the sale, but in turn, the reward is a large payoff when the property is fully operational and rebuilt.
Value-add investments require some renovation and often have moderate vacancies. These properties usually have deferred maintenance, but all systems are still running properly. Value-add properties offer significant upside, however, there is lower risk than distressed, and they also offer consistent returns for the majority of the project. Value-add investments are a happy medium between distressed and turn key.
To better understand why value-add investing is our preferred strategy, we first need to understand how commercial real estate is valued. Commercial real estate (CRE) is primarily valued based on a property's net operating income (NOI) and the local cap rate. The NOI divided by the cap rate yields the projected value. Therefore increasing the NOI increases the value of the property. This means the value of a commercial asset is determined by its financial performance (profitability). This method is different than residential property which is valued solely based on comparable sales.
For example, a turnkey investment property performs efficiently upon purchase and will cost the highest price as there is little to no work to be done. Distressed properties are performing very poorly or not at all, so they are valued the least upon purchase, but require a high investment in the renovation. Value-add properties are performing moderately compared to the other assets. They are likely getting by, but are not running efficiently. There are improvements that must be made to get it to perform better, therefore, it is priced lesser than turnkey but higher than distressed. Again, the happy medium.
Value-add properties focus on increasing the value of the property by increasing the income, decreasing expenses, and adding other benefits. These improvements increase the financial performance of the asset and therefore increase its value. For example, if a property has an NOI of $100,000 and the market cap rate is 5%, the property should be worth $2,000,000. However, if the NOI is increased to $120,000 with the same market cap rate of 5%, the property is now worth $2,400,000.
The simplest way to increase the NOI and therefore add value is by raising all under-market rents to current prices. NOI can also be increased by implementing a ratio utility bill-back system (RUBS) to bill back residents their share of utility costs. There are also many fees that can be billed to residents to increase property income. Fees such as laundry fees, pet fees, move-in fees, and or technology fees.
As there are many ways to increase income the same applies to expenses. Older buildings are often outdated and systems may be less efficient. For example, older toilets use much more water than newer toilets. It may be worthwhile to replace all toilets to reduce water use which would decrease annual water expenses and increase NOI. Another option is to separately meter each apartment's utilities so that they can each be monitored individually. Individually metered apartments are more reliable than RUBS but are much costlier. It is also a good idea at purchase to audit all contract services such as landscaping, snow removal, pest control, management, etc. for inflated costs.
There are other ways that help increase NOI indirectly that have a major impact on a property's performance such as branding and amenities. These things are advantageous to apartment communities because they increase demand and improve the property image which will increase rent and resident retention. For example, a value-add business plan may include adding a dog park or a children's playground to the site while also rebranding the property with a new name and all new signage and landscaping. These can be hefty upfront costs but may bring higher paying residents in that will stay longer which will increase NOI and property efficiency.
Here is a full example of a value-add business plan:
123 Main St
Purchase Price $2,100,000
Number of Units: 20
Cap Rate: 5.5%
-Renovate all units with new paint, flooring, fixtures, and appliances.
-Raise rents from $875 to $1400 after renovations
-Increase income with RUBS by billing back $50 per unit for utility usage
-Add pet fees, move-in fees, and increase laundry costs
-Improve exterior landscaping to be more welcoming and cozy
-Rebrand community with new name and signage
-Add a dog park
-Add children's playground
Disposition Price: $3,237,666
Cap Rate: 6%
Net Proceeds: $972,666 (Plus cashflow, tax benefits, and principal paydown)
In the example above, you can see that by improving the image of the property and increasing the NOI, the value of the property increased from $2,100,000 to $3,237,000, creating nearly $1MM in profit. While renovations on this project are being completed, there can still be enough cash flow to cover expenses to mitigate risk. For these reasons, we believe value-add is the best investment type for our investors.