The phrase “value add property” is thrown around quite frequently these days. This investing strategy is without a doubt one of the most popular in the multifamily space, and especially so in recent times. But how exactly does the “value add” component of an investment occur? What does this mean to the investor? Let’s look at 5 very common and popular ways an investing team will execute on this strategy. and increase the NOI (Net Operating Income) of a property. In summary, executing value add improvements can be done either by raising sources of income, or controlling/improving expenses.

Here are five very popular and common ways to improve value of a multifamily asset:

• Improve overall property management – The property manager will oversee the day to day operations of the asset including administrating leases. If the existing firm isn’t doing a “great” job, there may be room for improvement – in some cases this can be substantial. What are some signs to look for? High levels of vacancy (higher than average for the submarket), high levels of expenses/repairs, and dissatisfied tenants via negligence are a few examples of areas to improve.

• Perform exterior renovations – Many successful value add operators like to begin renovations “from the outside in” with the idea that a more attractive exterior will attract tenants quickly, even before interior renovations. Many tenants seek a property that will make them proud to live there and keep them for long periods of time. Specifically, a few examples in this category we’ll look to improve or transform include landscaping, add or enhance lighting for curb appeal and safety, clean/pressure wash all high visibility areas, improve signage/marketing, and perhaps add or improve attractive fencing around the property.

• Perform interior renovations – Common interior upgrades may include fresh paint, kitchen and bath renovations, flooring, light fixture upgrades, and furniture/furnishings (if rent/leasing furnished of course). The level and depth of upgrade will be matched to the market needs and may depend on the class of asset. For example, a “C” class asset may receive laminate countertops and black appliances where a “B” or “A” class asset may command granite countertops and stainless steel appliances. Targeted upgrades in this area can really make a difference in driving market rent and demand for quality tenants.

• Add amenities – An operator may choose to add amenities to an asset with examples such as dog parks, grilling areas, swimming pools, gym/fitness centers, and laundry facilities. Some of these amenities such as the laundry area may also be a direct source of revenue – this can be especially lucrative to owners and also adds convenience for tenants.

• Add or amend utilities chargeback program – If comparable properties are not including utilities in the base rent and the asset being acquired does include them, there may be an opportunity to implement a utilities chargeback program to recapture those costs and drive additional sources of income. This again may generate an additional source of income, but must be aligned to sub-market comparable properties.

During the due diligence period of an acquisition, we will evaluate comparable properties to determine where we can best place investment dollars in areas such as the examples above to make the biggest difference in terms of driving NOI (net operating income) improvements. The end goal is to improve the tenant experience while maximizing profitability of the asset. We hope you’ve enjoyed this article and learned a few things along the way. If your interest has been captured and you’d like to learn more, please don’t hesitate to reach out to me at [email protected].

Written by Andrew Schutsky as part of the Multifamily Scrum Series

When first opening an Offering Memorandum (also referred to as an OM), which is a summary of an investment typically prepared by the managing team, one can easily become overwhelmed with flashy graphics, pictures, and tons of property, financial, and market data. If you’re viewing this as a potential investor, you can save a huge amount of time IF you know what is critical. When viewing potentially dozens of investments in a short period of time, focus and attention are absolutely critical to maximize your precious time.

Let’s get right to it – what should an investor look for? Each OM may have a different flow of information, but the critical sections should contain the following – here’s a glance at each section and we’ll soon follow with details to look for in each section:

• Asset Fundamentals

• Business Plan

• Financials and Projections

• Location / Market Data

• The Managing Team

Asset Fundamentals

In this section, the physical details of the asset should be clearly outlined including the age/vintage, number of units, unit mix (bedrooms and bathrooms), amenities, and the asset “class.” This could be details of a single property or a collection of properties, otherwise known as a portfolio. It may also include other details such as the type of plumbing, electrical system(s), roofing type(s), and other nuances or features of the property.

What to look out for: Pay attention to the age/vintage of the property, amenities, and asset class. Specifically, older properties with flat roofs or cast iron plumbing can be problematic areas if not addressed – ask your sponsor or selling broker if they are on the watch list for risks and/or detailed inspections. Perhaps they have been addressed, but always worth asking. As for the asset class, look to ensure it’s going to be managed by a property management team with experience specifically with this type of property. More to come on the managing team later.

Business Plan

In this area, look to answer the questions:

• Why Should I invest In this Asset?
• What is the Investment Strategy? Is this a stabilized long term hold or a value add/growth opportunity?
• What are the projected returns? What is the expected hold period?
• What assumptions are made with the expected returns? Are the growth assumptions in line with the market and comparables?

Most importantly, does the business plan and expected outcome align with MY goals?

One important tip to note: One can not compare expected rate of return across different projects (annualized or IRR) without considering all of the items above – not all investment strategies use the same assumptions! For example, one plan may assume a 4% rent growth year over year where another may use a much more conservative 2% assumption even in the same market! This can a massive impact on the projected returns!

Financials and Projections

Many novice investors will quickly pass through this section – normally due to information overload! Don’t make that mistake, but rather break this section down into two sections:

Income – Look for gross potential rent to see what the property is capable of as well as what’s being projected during the hold period. Also be sure to look for allowance for vacancies, bad debt, and “loss to lease” which is essential the gap between current market rent vs. what is on the lease. Our rule of thumb is when underwriting allow for at least 10% off the top when accounting for those three factors. Also look for other potential sources of income like pet rent, laundry, utilities chargeback, and possibly other amenities. As noted above, pay specific attention to the projected rent increases over the years and ask how that would be achieved and how it compares to the comparable properties mentioned.

Expenses – A general rule of thumb (at least for the first holding year) we use is that expenses should should be at least 50% of the income as a conservative (and generally realistic) guideline. This will vary by market, but this is typically the minimum we’ll use to underwrite. The categories here are generally common with the big ticket items being taxes, insurance, turnover costs, and repairs. Be sure a reasonable allowance (250-350 per unit generally) is made for replacement reserves – most lenders will require this anyway.

Location and Market Data

There are a few factors we consider essential when evaluating or selecting a market to invest in, these include:

• Availability of jobs and job growth

• Income growth – this allows for the increases in rent growth to meet our business plan. We also look for a income/rent ratio of at least 3x the target market rent projected in the business plan

• Diversity in job sectors – generally do not want to be in or around a town that is a “one trick pony”

• Population and Population Growth – we like to start with those in the top 20-30 growing cities list and will look for where the population is moving INTO, not exiting like many cities typical in the Northeast at the moment

• Market size – we generally look for cities/MSA with >100,000 people at a minimum

• Schools – being in an area that attracts families is a plus

• Crime Data

• Market/Sub market average vacancy rates – how do these compare to the property?

The Managing Team

 Just as important as the asset itself, if not more important, is the credibility and experience of the managing team. After all, even the best purchase in the wrong hands is not going to be set up for success! Some key questions to ask with regard to the managing team:

• How many acquisitions has the team taken full cycle from purchase to sale?

• What are the roles and responsibilities of each team member?

• What results have been achieved with current or prior projects?

In Summary – These 5 key areas of focus are critical when evaluating each deal. We hope this brief article will save you a tremendous amount of time when evaluating deals.

Part of the Multifamily Scrum Series | written by Andrew Schutsky

Are you and the general partnership team personally investing in this project?

As an investor, you want to see the sponsor(s) investing alongside the other limited partners. This ensures that all parties interests are aligned and suggests the management team believes in the property and projected returns.

Who are the primary management team members and what is their track record?

Ideally the sponsorship team has significant experience in the asset class, market, and business plan type (value-add) in which they are raising money for. In the example a lead sponsor is new to the market, have they aligned themselves with an established property manager, contractor, and team?

What happens if you cannot make the projected returns?

Generally speaking, preferred returns will accrue and have a catch-up provision clause. This means that if a project has not hit the preferred hurdle rate that the shortfall will be added to a running balance. The GP team will not receive any portion of equity until this balance has been paid thru future cash flows or sales proceeds. Check your PPM (private placement memorandum) for full details.

What is the projected timeline for this project?

Most multifamily syndicators are looking to execute a business plan in a 3-7 year time frame. Some are shorter, heavy value-add assets while other properties may be a longer buy and hold strategy.

What are the biggest risk(s) of investing in this asset?

You should never hear from the sponsor that there is no risk, as every investment carries some level of risk. For multifamily, the risks generally fall under the market, deal/financing, or the team. Understand what the uncertainties are and whether you feel comfortable with the offsetting upside.

What are the first three things to be done after closing?

By asking this question, you should understand the initial priorities of the management team in addition to confirming the business plan is well thought out.

How does the first year’s financial projections compare to the trailing twelve months?

As a limited partner, you will want to understand the business plan and economic pro forma projections. Value-add investments will aim to increase rental revenues while also potentially decreasing and optimizing expenses. Asking the sponsor for a comparison will allow you to analyze the plan and determine if the projections appear too aggressive.

What is the going in cap rate and projected exit cap rate?

As a reminder cap rate is net operating income / purchase price. It is common practice to add approximately 10 basis points (bps) to the entry cap rate for every year the property is held. This introduces some conservatism into the underwriting as future market rates are unknown.

Do you plan to refinance the property, and if so will limited partners stay invested in the deal?

Inquire whether the projected returns include a refinance and determine whether the strategy makes sense (eg a capex plan with value-add play). If the property will be refinanced confirm that investors will continue to maintain their equity shares. This is beneficial for LPs whose return of capital is accelerated but also continue to earn the equity split.

What type of reporting do investors receive?

Each investor will have a personal preference on the cadence of communication they are seeking. Sponsors vary in that some may provide monthly updates, others quarterly, and some annual. Make sure if you want to receive monthly updates that you are not investing with a team that will only reach out once a year.

Part of the Multifamily Scrum Series – Written by Brian Pownall