The Importance of Value-Add Investing
By: Carl Pankratz
In Part 1 of this series, we outlined the overall benefits of investing in multifamily real estate. Part 2 included reasons why property management is key to success (and how we emphasize in-house management for the benefit of our investors and residents). In this, the final installment, we discuss why value-add can be a primary vehicle in achieving investment targets.
Apartment properties come in many different classifications. Properties are often referred to by property class (A, B, C and D) based primarily on age but also somewhat on condition and location. There are also specialty classes like student housing for properties that rent by the bed near college campuses or low income housing where many units are restricted on how high the rents can be as well as how high the income can be of the residents that live there. There are some outstanding opportunities for value creation when investing in apartments that appeal to middle or working-class families that need renovations or upgrades; these are considered or value-add apartments. As we discuss this value creation, there are three areas we are going to highlight: ways to create value, prohibitive nature of building new product, and the demand for workforce housing.
First, value-add properties offer an investor significant avenues to increase the value of a property while improving the surroundings for the residents and often have a positive influence in the communities surrounding them. These assets, which are generally 10 to 50 years old, often have dated interior finish-outs and the exteriors and amenities may be in some level of disrepair or at least not up to the standards of newer properties in the area. The changing styles and preferences over time make it possible to bring in modern designs and ideas to refresh the space, making it more appealing. This improved appeal generally leads to higher rents and better investor returns. Ideas to make spaces more attractive to current and prospective residents include: revitalized kitchen cabinets, backsplashes, new flooring, improved lighting fixtures, and new appliances.
All these, and other upgrades, can lead to rent premiums. However, as we discussed in the previous article concerning property management, it’s important to partner with an investment group that understands the highest and best use of rehab funds in a project. In some cases, smart home technology may be a good investment; however, in some markets it is an excess whose cost will never be recaptured. Utilities are also routinely higher at older apartment communities. Thus, bringing in water conservation measures or energy consumption improvements can also be a big benefit to the property’s bottom line. Whether it is improved finishes, energy efficiency, or better management, these properties can offer big investment upside.
A second factor in the benefit of investing in value-add multifamily is that building new affordable housing for residents close to jobs is challenging. Today, many factors weigh against the ability to build properties with rents middle and working-class families can afford. Finding labor is very challenging. In a market with a booming economy, trying to find a quality crew experienced in construction will come with a cost, as the demand for their services has outpaced the supply. Additionally, material costs are increasing, land prices are higher, there is limited multifamily zoning in desirable areas and building codes are more onerous than ever before. All of this has resulted in a cost of bringing new product to market that has increased dramatically throughout this economic expansion. Higher costs when building new properties results in rents at those communities that are significantly higher than many working-class families can afford. This insulates the market for properties that are a bit older, as even after renovation they can often be acquired for substantially less than current replacement cost. Value-add properties also have the advantage of already being occupied in most cases. When new properties are built, a substantial amount of the investment time is spent with negative cash flow as the units are not yet occupied and often large concessions have to be given during the lease up period.
Last, a big driver for value-add multifamily is the huge demand from working families. Workers with jobs essential to schools, police and fire departments as well as the service sector cannot afford housing that is conveniently located to their jobs. Using numbers from the National Multifamily Housing Council, there is a 3.1 million unit shortfall for working class families in the United States. This has been made more difficult, by the lack of supply on the market. Per the Joint Center for Housing Studies of Harvard University, the national vacancy rate for both owner-occupied and rental units fell to 4.4%, the lowest point since 1994. This provides an incredible demand for a limited number of units. Many renters are pushed to areas outside of where they work in order to find apartments that are affordable. These apartments are typically the apartments that are older in age and in need of an upgrade. These residents may not be able to afford the rents of a new building, but they still desire a clean and nice place for themselves and their families to call home. Many times, the apartments that were built prior to 1990 were built in locations close to core urban locations, and by upgrading the units, residents now have a clean and safe place to live, close to their employment. Therefore, nicer appliances, well designed kitchens, and other updates have value, as it still allows a rent that they afford but with the quality they desire. This drives the huge demand for value-add apartments.
Throughout this series, we endeavored to provide information on the multifamily process, while empowering you to make better investment decisions. You have hopefully seen the benefit of multifamily, the important role that good property management plays, and the demand from renters for value-add apartment communities. As you move forward, it’s important that you invest with a partner that has experience in the space and ask the “right” questions. Multifamily investing can help you achieve your financial goals; please reach out and let us know how we can help you in your journey.
Over the last decade, Exponential Property Group has given hundreds of investors the opportunity to grow their net worth using multifamily real estate. Go to exponentialpropertygroup.com/invest to learn how you can too.