What is the Multifamily Value-add Model?
Value-add investing has been one of the most tremendous plays in a real estate investor’s playbook for decades. I am going to break down the phases and steps a syndication group goes through to acquire a multifamily deal from start to finish, and add value to increase cash flows and appreciation of the asset!
Step 1 – The Acquisition of the Asset
Deal flow is important. Sponsors must set up processes to find great deals for investors. Once a quality asset is found and gets put under contract, the next step is physical and financial due diligence. The sponsors will build a business plan that pinpoints expenses, value add construction schedule, cash flow projections and exit strategy. During this time the sponsors will also get financing and insurance. Once the financial model is complete the sponsors will move forward with sharing the deal with equity partners and limited partner investors. The sponsors will then travel to the asset to conduct door-to-door physical due diligence of the entire property, during this period they will find additional savings and additional improvements where value can be added in year 1. When the seller and buyer come to terms on the contract then the property is closed and officially acquired by the sponsors.
Step 2 – Adding Value
The adding value step is important because this is where upgrades, improvements, and a better experience come for tenants. Often real estate sponsors will start with improving the exterior of the property to include new paint to make the property pop and look fresh from a curbside appeal. Sponsors are likely to improve signage on the property with a fresh rename of the asset and take measures to improve landscaping, lighting, community areas, parking, walkways, and outdoor amenities like dog parks, pools, and barbeques.
Common interior improvements include upgrading cabinets and fixtures, flooring (new vinyl planking in kitchens/bathrooms and dining areas, and new carpets to bedrooms), adding washers and dryers, and new LED light fixtures. It is critical that the sponsors upgrade the units to market standards without overspending on the capital improvements based on the likely tenant base. If the area calls for nicer improvements then the sponsors will consider marble countertops, high-end fixtures, and new toilets and showers.
The sponsors have to be well versed at matching the tenant’s needs, the prices of the remodel to include construction costs and vacancy costs, and the likely rent bumps that will occur from the new model without going over budget. This is why it is SO IMPORTANT to have a detailed model that has been fully vetted by a third-party professional property management company and a third-party contractor.
Numerous sponsors look to upgrade each unit as the unit is “turned.” Meaning that as an old tenant is leaving the unit is remodeled before the new tenant arrives, and the new tenant will pay a premium for the newly remodeled unit. Some business plans do not require all the units to be remodeled which “leaves some meat on the bone” for future investment sponsors to acquire the property and continue to remodel, or complete the remodel. Again, it all comes down to the business model and how to maximize returns for the investor.
Step 3 – Refinancing the property
Commercial buildings are valued based on the money they generate (NOI: Net Operating Income), and the goal of the refurbishment phase is to improve NOT by obtaining higher rent premiums in the newly remodeled units.
Most tenants will gladly pay an extra $150 per month for the option to move into a renovated unit. If the apartment complex has 100 units, that’s an extra $15,000 in rental revenue each year, equating to $1,500,000 in increased equity at a cautious 10% cap rate.
A sponsor may use the extra equity to refinance the property which could return a portion of the investor’s capital or all of the investor capital depending on the terms. For example: assume you put $100,000 into a value-add multifamily syndication, and the sponsors refinanced the property after 24 months, returning 50% of your initial investment. This is the point at which you should rejoice because you’ve now received $50,000 of your initial investment, in addition to ongoing cash flow dividends of 5-7 percent on your original $100,000 investment.
If the market is favorable, sponsors could elect to sell the asset early. Another option is to conduct a 1031 exchange for a larger asset that can provide more cash-flow, without incurring a taxable event. It is important to note that all these scenarios should be considered in ACQUISITION. You make money when you buy the RIGHT asset.
Step 4 – Holding the Asset long term
Multifamily real estate investments are often held for 3-10 years. As the value add process is happening the sponsors pay close attention to bringing in quality tenants and creating more revenue. The revenue increase directly increases the Net Operating Income, which directly impacts the value of the property before it sells.
Step 5 – Sell the asset
Now that the property has been improved, NOI has increased, and appreciation has taken place, sponsors can sell the property. This allows investors to get all of their capital back or, sponsors can do a 1031 into another deal or investment without having to pay capital gains tax.
In some instances, if during the refinance phase sponsors can return all of the capital and hit investor returns sooner to do another deal, and the sponsor could hold onto that new apartment for decades moving forward creating cash flow. When this happens the LPs (limited partners) get their capital back and can take part in the next deal.
Boom. There you have it. These are the steps often found when doing a multifamily value add deal. If you would like to learn more about how you can invest as a partner in one of our deals please reach out to us at our become an investor page.