The Definition of Value-add
The definition of ‘value-add” in the real estate investment world is “the asset in need of work that can be improved to optimize its income potential.” In the commercial real estate realm, a multifamily building, or an apartment building, is a building with more than four units. A typical value-add opportunity might be an asset purchased by an investor where considerable maintenance has been foregone, or deferred. It’s in rough condition, has been poorly managed, resulting in a lot of vacancies. In an ideal world, the asset should be producing the maximum amount of income for the investor. That maximum amount of income would be determined by market rents of similar properties. If, however, the asset has been neglected there might be an opportunity to “add value.”
Currently, in the Denver market, the demand for these types of assets is very strong. However, they are in short supply. The market has been picked over. We get 15-20 calls per week from out-of-state investors seeking exactly this type of asset.
The Value-add Process
The asset, for example, could be an apartment building built in the 1950’s. It has avocado-colored appliances, ceiling tiles, broken tiles in the bathroom, worn out carpet, scarred kitchen cabinets, along with a stained bathtub. The rents are below the market. In order to add value to this the building the investor would wait until the leases expire and would not renew the leases with the existing tenants.
The investor defines the budget and begins to improve the units to the market standard. If the leases termination dates are spread out over many months, this might take a year to accomplish. He then raises the rents to the market rates.
Once that has been accomplished, he can refinance the asset, buy another, put it in the bank, or stuff it under his mattress.
Cash Flow Impact
We see renovations that often cost from $10,000 to 15,000 per-unit. For small apartments (500-600 square feet) that’s just about everything except for the main guts of the building. It is common to see cabinets, countertops, appliances, paint, bathroom tile, some light fixtures and flooring in the renovations. Depending on the market and the area in Denver, the investor can generate anywhere from $200-400-a-month increase in rent. A $12,000 investment in the unit that generates a $300-a-month increase in rent is a 30% return on the $12,000 invested.
Cap Rate Impact
The capitalization rate, often just called the cap rate, is the ratio of Net Operating Income (NOI) to property asset value. Assume a property has net operating income of $100,000 and a value of $1,000, 000.
Capitalization Rate = Net Operating Income/ Value
Example: Cap Rate = 100,000 / 1,000,000 = 10%
We have a client who has a 30-unit apartment building for which he paid $3.7 million, or $123,000 per door. His out of pocket cash invested was $1 million. He invested an additional $400,000 in those thirty units ($10,000 per door, plus some other exterior improvements to the building) and now sits on an investment producing an increase of $300 per month rent per door, or $3600 per year additional income per door for a total of $108,000 for the entire building (2.6% increase in the cap rate: $108,000 / $4,100,000 = 2.6%).
The bank recently appraised the building at $4.8 million.
The owner had $1 million in equity when he purchased the property, or roughly 30% of the $3.7 million purchase price. He invested an additional $400,000 in those improvements, totaling $1.4 million cash invested. He then had it appraised and it came back at $4.8 million. The difference between the appraised value and the purchase price and improvements totals $700,000, which he can “cash out” and use to buy another investment property.
Value: $4.8 million
Original Purchase Price: $3.7 million + $400,000 in improvements = $4.1 million
Cash Available: $700,000
If you own a building that’s dated, has deferred maintenance, the furnace, water heater, and roof all need to be updated, now is a really good time to make the investments in the upgrades or sell it to somebody like me and one of my investors that know how to do this. I get a lot of phone calls from Philadelphia, Chicago, and California from people who have anywhere from $5-25 million to invest. They want to get into a market that’s less expensive and Denver is their “secondary” market. Most of them want to buy a property that needs work, but I tell them they are five-years too late to that party.
By the way, if you own one of these and you want to sell it, call me. I’ve got $100 million that we can place today if we had the buildings.
Multifamily Assets Are Over-priced
Pro forma income statements are not the same thing as actual income statements. Because of the high demand for multifamily assets in the Denver market, owners are listing them at a pro-forma derived cap rate of 5 to 5.5%. This assumes that the purchaser can make the investment of $10,000-$12,000 per door, re-lease the units at a higher rate and generate a 5.5% cap rate. Today, in its actual condition, it might be a 4% cap, which is an expensive property. However, these assets continue to sell.
The Importance of the Right Property Management Team
In this market there is a lack of professional asset management. If the manager or owner does not keep his maintenance up to date, or has bad tenants, or high vacancy rates, the value of his asset will fall. Properties managed in this way are what the “value-add” investors are seeking.
On the example given above, the previous owner was absentee. He bought the property sight unseen. Luckily for him, it was actually a good purchase. He paid $2.5 million several years ago. He, however, did not hire the right property management company. He had a “manager,” but because of his (the owner’s) life complications he did not manage the manager well and the property deteriorated. The profile of the targeted tenants was inappropriate. As a result, the property was getting frequent visits from the police. This generated eight vacant units that were all in some really bad condition.
As soon as our current owner came in, that property manager was removed. The new owner started remodeling units. He hired another property management company, Grace Property Management, and they have absolutely knocked it out of the park. They have been detailed. They are communicative. And they brought in good tenants. They don’t let a unit sit vacant. If there is something that needs to be done to that unit between tenants, they do it immediately and they get the most money they possibly can out of each apartment in that building. They always push the market price a little bit, constantly focusing on how to generate a better return for the owner.
To determine how much more rent you can generate use rentometer.com. There you can see what similar size units in your area are renting for.
If there’s work to be done you need an extremely experienced and qualified group to do that. You have to manage the budget. You have to manage the timeframe. Every month that goes by that one of those units is under construction and not being rented is costing you money. It can be tough to get suppliers in there on a piecemeal basis. You are not hiring somebody to renovate a 30-unit building. You’re hiring somebody to renovate one unit. Then the next month you have to get them back out there to renovate another unit and again the next time. That’s tough to do.
You have to manage contractors. You have to manage the management company.
In the office and retail space it’s the same equation for success. You can add money to an office building or a retail strip mall, make it nicer, put new carpet in, repaint it, give the exterior a facelift. Pay an architect $10,000 to design a really efficient front facade for the building that makes it look like it belongs in today as opposed to 1956. Spend $10, $20, or $30 per square foot and produce higher rents.
The Current Market
The inventory for value-add properties is low. The assets may seem to currently be expensive. However, we must consider that Denver’s economy is very strong. New businesses are being created and established businesses are moving here at a rate never seen before. According to the Economic Innovation Group, Colorado has more new businesses (as % of total existing businesses) than any other state except Utah.
You might think that real estate is expensive now, but just keep in mind, rents in California are twice as much as Denver. That makes us a pretty attractive place to be.
If a smaller investor has a long-term perspective, he can benefit from this market. Assume he buys an income-producing asset for $2.5 million. The building has annual income of $125,000 (125,00 / 2,500,000 = 5%) with a 5% capitalization rate. Assume further that he leases the building at that beginning rate of $125,000 per year, but his lease contract includes a rent increase of 3% per year for the 10-years of the lease term.
As the two charts that follow demonstrate, at the end of the 10-years his annual income has increased to almost $168,000 and after making all of his mortgage payments he is left with $160,900. He decides to sell the asset at the same 5%-cap rate and his sales price would be $3,359,790 ($167,989 / .05 = $3,359,790) or an increase of $859,790. In addition to the profit from the sale, the tenants have paid his mortgage during the time he owned the property.
There are many comments in the press about the rate of increase in rents and the rate of increase in wages. Wages are not keeping up. If this trend continues, then eventually there will be an economic clash between rents and wages. Will Denver become unaffordable? Perhaps in the Central Business District (CBD).
From the Great Depression of 2008 until now, the data clearly show that the total Denver apartment market is not over-built. After the crash, the rate of construction of new apartments fell dramatically. Even with the seemingly irrefutable evidence of construction cranes in the CBD, the market still does not have enough units. Yet, in the CBD there are new apartment buildings where the owner is giving two months free rent, just to fill up the units. The “experts” say the millennials want to be in the CBD, but the cost of these units is driving many of them away.
In the B markets, this is not the case. Assume there is a building that’s ten minutes outside of downtown Denver that is a little bit dated, but the rent for a one bedroom might be $400 per month less than in the CBD. They rent quickly. In the office market the rent differential is even higher. In the CBD the rents are $40-$45 per square foot (PSF). In the Denver Tech Center (DTC), they are at $27 PSF, while in Aurora the office rents are at $20 PSF.
B markets on the outskirts of downtown are a good place for them to start looking.
Driving east from the CBD toward Washington Park along Speer Boulevard there are older buildings. Up and down Logan on the west side of Washington Park and in Capital Hill there are older buildings. Look anywhere near the Highlands at some of those older buildings. They’re going to be expensive with low cap rates, but they are not going to have any vacancy. You’ll be able to gradually increase your rent and ten years down the road you’ll have quite a lot of equity.
At 7th Avenue and Washington Street, which is a historic district, there is a listing on the market for $1.25 million. It’s a six-unit apartment building, probably an old mansion converted to apartments at some time over the last 40 years. The current owner has owned the property for 40 years. It is listed deceivingly at a 5.5% cap rate. What they don’t tell you on this listing is that it’s a 5.5% cap rate on what you should be getting for rent, not what they are getting for rent.
If you calculate the cap rate using the asking price versus the actual net income on this property, it is a 3% cap rate. The seller is proposing that without doing any work and just re-renting it at market rents, you should be getting a 5.5 cap rate. That may or may not be true. It’s just an example of how expensive these small older buildings are. This is a very, very good location, has easy access into downtown and uptown and basically anywhere you want to go in the city. Paying a 3 cap for a building in good condition may not cover your Debt Service Coverage Ratio (DSCR) so one must be careful.
Denver is a tough place to buy right now. The point is, if you own one of these things already, you’re in really good shape. If you try to sell it at a 3 cap you’re probably going to have a tough time. If you want to sell it at an actual 5 cap and leave somebody some room to actually do a value-add, that will work.
There are deals out there, but they are hard to find. Give me a call. We’ll discuss it. There are opportunities to build. It’s longer-term and more work, but it’s the only way to get you in at 7 cap or better. We may have to go find them grass roots style and start knocking on doors. We’ve got to go direct to the asset owners and see if they’d be willing to sell these things.
If you’re going to buy a multifamily property in this market, you’ve got to be somewhat aggressive and manage the asset for the future annual appreciation in rent.