“Value-add” may be the most overused term in multifamily investing today. Seemingly, if a property was built prior to 2020, its now a value-add. Is it really? The term references the incoming buyer’s opportunity to improve the property, grow its income stream, and increase its market value. This can be accomplished either through renovations/updates resulting in rent increases, operational cost reductions, or both. If executed properly, a combination of these implementations would result in an increase in net operating income, and a subsequent higher market valuation.
But just who is the “value” being created for? I ask myself this when looking at many of the offering memorandums I see marketed as of late. Is it the seller? The contractors, brokers, lenders, lawyers, or any other vendor involved in the transaction? These folks are all gonna make out just fine and find a lot of value in this market when they cash-out or provide their services. However, if you are the buyer or investor, YOU better be the one getting the value, as well as the residents of the community you’re buying!
In today’s market, its not uncommon for a property to be on its 4th or 5th value-add cycle. Each buyer takes a crack at making some improvement, or just riding the appreciation wave for a year or two, then lists including a sales pitch that there’s a proven plan that just needs continued execution to add to the already lofty market price.
So, how is a buyer to know whether there’s really any meat left on the bone for them? It comes down to the scope of the project, understanding a few key metrics, and applying them to the specific market and asset class in question. These are the questions I ask when evaluating a deal:
- What’s the property class – A,B, C or D?
- What’s the cap rate for the class of property in the specific market?
- What’s the yield-on-cost?
- What’s the developmental spread?
- How do we weigh risk adjusted returns with the scope of the project?
First, what class of property are you underwriting – A, B, C or D? The location, age, condition, and operational status of the property are all going to dictate its class. Here in Indianapolis, for example, Class A new construction is trading at sub 5-cap prices. Class C is trading closer to a 6-cap. Class D could be 7-10% depending on how distressed the property is and where its located. Knowing your market street-by-street and understanding what other properties around are trading for is paramount.
Armed with this information, you can start to underwrite specific deals. Yield-on-cost is extremely useful to begin to measure a potential value-add project’s viability. When calculating an in-place cap rate on a value-add project, you’d divide the current net operating income by the purchase price. But what if you have a $400,000 renovation budget that will result in higher rents? That cap ex budget is not accounted for in the sale price of the property. Yield-on-cost will, however, take this into account.
Example: A value-add project has an NOI of $120,000 and a purchase price of $2,000,000, a 6% in-place cap rate at acquisition. The operator injects $400,000 to update the property, bringing the total project cost to $2,400,000. The improvements allow for higher rents and lower expenses, bringing the NOI up to $200,000. This results in a yield-on-cost of 8.34% (YOC = pro forma NOI/Total Project Cost – – – $200k/$2.4M).
Having this knowledge is critical as a point of comparison between yield-on-cost and the market cap rate for the specific asset class in question. The difference is the “development spread.” In the example above, if the market cap rate were 7%, with a yield on cost of 8.34% (a development spread of 134 basis points), you can be confident that the renovations are leading to actual value to you or your investors. The higher the spread, the better. Notice that the in-place cap rate of 6% differs from the 7% market cap rate in the example. You do pay a premium for upside potential, but you shouldn’t pay so much for it that your development spread is wiped out.
Sometimes its worth taking a step further if there are some operational implementations that are relatively easy to implement. For example, let’s say the seller is paying 4% for property management and you know you can plug in your management team for 3%, day one. By calculating NOI using trailing effective gross income minus stabilized expenses (your projected expenses), you can look at the developmental spread from a different lens – one that just measures the value created from the renovations and updates planned. This tweak can potentially better measure the effort and sweat equity required to get to your desired outcome.
Now that you’ve got some data, there’s a qualitative component that enters the equation – is the risk and scope of the project worth the upside potential? This is all in the eye of the beholder.
If you’re dealing with a light value-add, 2015 build, that just needs some paint and a few amenities to achieve a rent bump, maybe a 50 basis point development spread is going to provide a solid risk-adjusted return. Alternatively, if you are dealing with a distressed, total reposition, that’s 70% occupied, with a ton of deferred maintenance, 50 basis points isn’t worth the risk. Even if the project is executed perfectly, I’d argue interest rate risk could wipe out that spread through a cap rate expansion. It would be a real slap in the face if you went through all the trouble of repositioning a heavy lift to find out you didn’t add any value at all. For a big project like that, you may want a 200 basis point development spread. Again, it’s subjective and upside should be carefully weighed against risk.
So, when you hear the term “value-add” moving forward, approach it with a critical eye. The value-add potential should be reserved for the buyer. Get out your calculator, cut through the fluff, and apply your market knowledge to hard data. Numbers never lie, but they can be presented in a way that tells a story benefiting the storyteller. If you strip them down, you’ll be able to identify the true value-add deals and buy them right – ones worth the effort and risk. Capitalize on those.