In today’s low-yield market environment of commercial real estate, value-add multifamily investments are gaining popularity among investors.
Real estate investors are preferring value add commercial real estate investments over stable assets due to their potential to win after renovations and infrastructure upgrades.
Furthermore, value add apartment investing strike a balance between stable cash flow and capital appreciation.
Therefore, value-added investments in secondary markets provide risk-adjusted returns to commercial real estate investors.
What is a value-add multifamily investment strategy?
There are three commercial real estate investment strategies namely core, value-add, and opportunistic.
Core multifamily properties are Class A properties in the best conditions and locations. Hence, these are the least risky of investments.
On the other hand, opportunistic multifamily properties are distressed assets that need complete renovations. Hence, these are the riskiest of investments.
Value-add multifamily properties hold a moderate status in the risk-reward spectrum.
This is because value-add multifamily buildings are in fairly good locations with a moderate infrastructure.
Typically, they have medium to high vacancy rates and deferred maintenance.
Once identified, a potential commercial real estate investor implements an overall asset stabilization strategy.
Specifically, a value-add strategy is all about purchasing a property at a decent price and investing money in its physical improvements to bring it up to the market standards.
Investors focus on maximizing the value of the property before exiting.
Therefore, multifamily value add investment opportunities have higher levels of risk.
So, such strategies involve significant capital funding for property upgrades, which reduces the return potential.
Hence, finding the best multifamily value-add opportunity is important to secure a healthy yield of income.
Read Lilypads’ article to understand the trends of multifamily investment in 2021.
Why invest in value-add multifamily properties?
1. Affordable acquisition cost
The foremost advantage of value-add multifamily investments is their affordable acquisition costs.
Compared to newer properties in city centers, value-add multifamily buildings in secondary markets are more cost-efficient investments for new investors.
2. Value appreciation
Besides generating a healthy cash flow, value-add multifamily properties undergo a significant amount of value appreciation during the hold period.
But, stable assets gradually compound their rate of appreciation annually.
3. Stable income flow
Value-add multifamily properties boost the ROI of the investors compared to core properties.
Although the initial cash flow may not be adequately high as compared to the Class A assets, operators can eventually balance the operating expenses of the property and its rental returns.
Typically, value-add investors aim for a steady cash flow after the stabilization of the property.
Then, the investor may choose to hold it or sell it.
Especially when the property is in a strategic location, investors can expect full occupancy rates.
Some investors purchase a value-add property that needs renovation. Or they use the cash flow of an existing property to rehab the property over time.
Either way, value-add multifamily investment provides higher returns than core assets.
4. Portfolio Diversification
A value-add multifamily investment diversifies the portfolio of a commercial real estate investor.
Passive investments through Real estate investment trusts (REITs), crowdfunding, or investing in value-add multifamily properties across various markets with local operators enable portfolio diversification.
5. Low-interest rates
Any commercial real estate loan will cost the borrower an interest rate depending on the deal type, sponsor quality, and loan source.
However, multifamily debt typically has the lowest interest rates.
Hence, the investors may receive greater returns after borrowing at lower fixed costs.
In recent years, interest rates for multifamily properties have been historically low.
So, multifamily investors can depend on government agencies like Freddie Mac, Fannie Mae, or Housing and Urban Development (HUD) for multifamily project financing.
6. Tax benefits
Value-add multifamily investments offer several tax benefits.
When a property is purchased, the asset’s depreciation allows investors to claim tax reductions as long as they own the property.
The IRS sets the depreciation time period at 27.5 years as opposed to the 39 years for other commercial properties.
As a result, investors can deduct 1/27.5% each year from their taxes on property depreciation.
Also, property owners can deduct the costs of maintenance, repairs, and other operational and property management costs.
Moreover, Real Estate Investment Trusts (REITs) also get preferential tax benefits from multifamily investments.
How to find the right market for value-add multifamily investment?
Multifamily value adds investment strategy generates attractive risk-adjusted returns for investors.
When an investor wisely finances property upgrades, they capture untapped revenue streams.
Indeed the property gets value, produces the highest level of returns, and compensates the upgrade expenditures with more profits.
However, accredited investors must carefully select the right market to map out a realistic ROI for a value-add multifamily project.
Year after year, the demand for multifamily properties is increasing with a surge in population growth and home prices.
So, these recession-resistant properties generate higher rents with increased occupancy rates.
Furthermore, primary markets are full of overpriced properties. Hence, the workforce is moving out of the core business districts. So, investors must invest in underperforming assets in secondary markets.
Therefore, they can utilize rent growth and face less competition from institutional investors.
Certain neighborhoods in secondary and tertiary markets have undervalued middle-market assets with growth potential.
These sub-markets are located outside or nearby core urban areas with advanced healthcare, educational and technological industries.
Furthermore, such sub-markets attract lower-income workers and an educated workforce due to their affordable cost of living.
Therefore, value-add investors must tap these transition areas.
Thus, they can use their strong economic trends and job growth in the adjoining urban centers.
How to find the right property for value-add multifamily investment?
Value-add multifamily investors aim to strike a balance between income potential and renovation risk.
Hence, they must consider the property’s age, amenities, size, layout, and location before purchasing it.
Since there is an oversupply of Class A properties in core markets, they cannot increase their rents anymore.
And, Class C properties have low tenant turnover rates that prevent rent increase.
Therefore, Class B properties are the ideal value-add multifamily investments.
These buildings allow light to moderate renovations. Hence, investors can justifiably increase the rents in return for high-quality housing options.
Furthermore, Class B properties allow tenants to access premium living without Class A rents.
Where to add value to a multifamily property?
Even if Class B properties are relatively new or less than 40years old, they likely need dated amenities and features.
So, value-add multifamily investors can add to their appeal and generate more returns through material upgrades.
It is not unusual for a class B multifamily unit to have sub-par doors and windows, poor carpeting, dull wall paints, unappealing lamination, and flooring, etc.
Therefore, investors can update the interior with modern décor, overall flooring, fresh coats of paint, and remodeled kitchens and bathrooms.
Converting a two-bedroom apartment into a three-bedroom one, installing individual washers, dryers, and providing high-speed Wi-Fi are also important modifications.
In addition to this, fixing electrical systems, HVAC, and heating and insulation promote sustainability and energy efficiency.
Moreover, these changes beautify the property. Also, investors can get these upgrades at huge discounts especially because they renovate multiple units on a large scale.
Value-add multifamily investors must not only restrict themselves to the interiors of a property but also consider material upgrades to the exteriors to enhance its curb appeal.
This includes updating the landscaping on the grounds and painting and rebranding a building.
Additionally, community upgrades like reserved parking, garages, pools and clubhouse, gyms, and pet parks, etc also improve the marketability of a multifamily property.
Besides investors should also hire a new property management team to ensure efficient operations.
Furthermore, functional security guards, fences, surveillance cameras, or even gated parking ensure tenant safety.
The Lilypads Bottomline
Indeed value-add multifamily investments provide risk-adjusted returns to investors.
So, acquiring value-add multifamily projects in secondary markets is profitable.
Commercial real estate investors with both long-term and short-term asset holding periods can get increased appreciation, boosted rents, high NOI, and lower cap rates post-renovation.
However, investors must refurbish an asset keeping in mind the market trends, demographics, and overall budget.
And, ultimately, a value-add multifamily investment can be successful only when an investor can maximize the returns and value appreciation of a property.