By Barbara J. Gaffen
Co-CEO-Prime Property Investors
As many of you know, multifamily is continuing its recent streak as the hottest sector in commercial real estate. Today, with financing sources opening up, investors and developers are building on the multifamily momentum with an increasing number of value-add plays, and they do not see these deals slowing down anytime soon.
Why value-adds are hot now
Value-add properties are currently a darling of the multifamily industry due to their strong return on investment. There also are more value-add buys to choose from today than in the past. And, with so many brand new high-end developments going up, projects that are 10 to 15 years old are often considered bargains as they can be updated to compete with many of today’s newest buildings, yet at a fraction of the cost of building brand new.
One of the keys to making a “value add” deal work is a successful financing strategy. As we are all aware, when the economy got bad, the only lenders were Fannie Mae and Freddie Mac, but that’s changed in the last couple years. Today, banks and insurance companies are financing loans again.
Financing your deal
When financing a deal, it is important to evaluate the amount of leverage you will need, the amount of equity you can come up with, the rate of interest and the desired length of the loan. For example, if you want to hold a deal for seven to 10 years, then you will not be concerned about prepayment penalties. But, if you want flexibility, you want to opt for shorter-term loans. Banks typically give shorter-term loans while insurance companies, as well as Fannie Mae and Freddie Mac, provide longer-term loans.
My firm generally prefers shorter-term loans for value-add deals. These loans allow us in a two- to three-year period to update and sell a property, or we can refinance after the loan is expired and cash out. We go with shorter-term loans when we expect to increase the value of a property in a short two- to three-year time limit.
The recent sale of our Deer Valley Luxury Apartment community in Lake Bluff, Ill., is a great example of this strategy. We worked with a bank for a short-term, three-year loan because we wanted flexible debt. In just under two years, we had the property updated, fully leased and sold it for a 31 percent profit. We bought it for $21,900,000 and sold it two years later for $28,600,000.
Three ways to finance a value-add multifamily deal
- Banks – Three-year loans from banks are a common product for multifamily deals. They can provide up to 70 percent leverage. Depending on the appraisal, banks can allow investors to also finance money for renovations, providing extra funds for upgrades. With a short-term loan, you can go back and refinance after three years if the property has not sold. If the value has increased, you will get a bigger loan and end up with excess cash, which you return to your investors.
- Fannie Mae and Freddie Mac – These lenders provide seven- to 10-year loans. Fannie Mae and Freddie Mac have been the go-to with the best rates in last number of years. They can provide up to 70 to 75 percent loan-to-purchase value. One drawback is these loans have stiff pre-payment penalites.
- Insurance companies – Insurance companies are lenders as well, providing three- to 10-year loans. Investors do not work directly with insurance companies, but rather through a broker who deals with different insurance companies and their financing vehicles. These loans can provide up to 60 percent loan-to-purchase value. A drawback is investors have to come up with 40 percent equity, but an advantage is the rate is low. And, you can choose from shorter- and longer-term loans.
How to add value
Typically, it is easier to upgrade a Class B property to Class A. Turning a Class C into a Class A property can be quite a substantial undertaking and requires more investment in upgrades, as Class C communities often have inherent structural features that are difficult to overcome such as window air conditioning units, wall heaters and lack of in-unit laundry. We prefer to find properties that need minimal updating to finishes rather than a very extensive rehab.
Renters like new finishes and do not like when units look like they are from the 1990s or earlier. Plus, cosmetic upgrades can really increase rental rates.
The improvements and renovations we made to units at our Deer Valley Luxury Apartments property primarily focused on updating all kitchens and baths. Kitchens were revamped with dark wood cabinetry, stainless steel appliances and granite countertops. Baths got new cabinetry, vanity countertops and faux wood vinyl flooring. Small upgrades like two-inch wood blinds and brushed nickel hardware made a big impact as well.
Entryways were updated with faux wood flooring, and we perked up all hallways with new paint, lighting and carpeting. We also upgraded the community’s fitness room.
Investors should crunch the numbers to determine the total cost and estimated timeframe for turning around a value-add property. You need to evaluate the costs of upgrades, look at the age of the property and research the competition as to their finishes and amenities.
For example, in the right market, putting in new kitchens and baths can bring in $200 per month extra in rent per unit. If you have 240 apartments, that increase means an extra $576,000 per year in revenue. This enhanced revenue can increases the property value by almost $5 million based on today’s cap rates as applied to net operating income.
We determined kitchens and baths at Deer Valley could be redone for $7,000 per unit. We upgraded them as units turned over to new leases, and we also asked existing renters before their leases were up if they would like to upgrade. We did not force renters to do it.
Deer Valley had about a 40 percent lease renewal rate, so right there we had access to upgrade 60 percent of the units when those renters moved out. With the rest of the units, many renters chose to upgrade. So, in about 1½ years, we were able to update almost all the units at a rate of five or six units per week.
If in a hurry, some developers will demand renters upgrade at lease expiration or some will empty half the units to upgrade them in a faster amount of time. However, you run the risk of losing that renter, plus, you lose revenue for the time the units are not occupied.
There’s no rule of thumb as to determining how much money to put into renovating a property. If you want to get the best value, you can and should stick to a predetermined budget. Our goal is always to increase rent roll on a steady basis to increase the value of the property.
In sum, there are numerous options for financing a value-add multifamily deal. We continue to like shorter-term loans because of the flexibility to sell or refinance if we want or need to. And, the rates of interest are very low. However, each deal is unique and there are numerous options to explore to make the right choice for your investment.