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REAL ESTATE Value Add Component

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SteveO

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In the thread titled Amazing Apartment Returns, the focus was on showing the returns as a result of income growth in an improving market. This post is to illustrate the potential returns from the Value Add opportunities in apartment investing.

One thing becomes very obvious when you are in this business. There is no shortage of mismanaged properties. The challenge is to identify them and purchase them at a good price. If done properly and efficiently, this will lead to incredible returns. Done poorly, and you may be one of those sellers.

The basic idea is fairly simple; find properties that are not maximizing income. This could come in many forms. Sometimes an owner of manager will try to cut expenses through salaries and staffing. This usually ends up that you get what you pay for. I have seen out of state owners hire someone to staff the office with inexperienced managers because they are cheap. Or hire maintenance staff that are not capable of handling standard plumbing issues. One key element is the ability to turn apartments over and get them ready to rent. Maintenance staff and management that are properly trained tend to be much more efficient.

There are also the owners that like to maintain a high occupancy. There could be a lot of opportunity in the statement "we are 100% occupied with a waiting list". This is a trigger to look at market rents in the area and see if there is room for increase. Sometimes there is a lot of room.

The element that presents the largest opportunity in my opinion is the owner that is too thinly capitalized. Any down trend or glitch in the rental market could send them into a downward spiral with little ability to recover. Some owners won't put money back in even if they have some in reserves. If the income dips below the expenses in these situations, something needs to be cut back on. These cutbacks can have severe consequences.

I have been to properties that have had 30% vacant and no units ready to rent. Units have been butchered for appliances, air conditioners, plumbing parts, etc... The managers have no money available to keep operations afloat.

These properties may be able to be purchased for a bargain. You may not get a favorable cap rate in these circumstances though. It becomes a "price per pound" at this point. Sellers will usually have a minimum price per unit. Your job is to figure out how much opportunity there is in these situations. Your pro forma becomes critical. The better you are at accurately predicting your operations, the less risk in the deal.

A word of caution here. Make sure that you understand how much money needs to be spent to bring the apartments back to favorable operations. This includes the money for improvements and the money needed to fund the negative cashflow while getting it back to normal occupancy levels. There is a lot of room for errors but a lot of money that can be made as well.

Mismanaged properties tend to really show up in markets that are on a downturn. Improving markets can cover a lot of issues for the owners. Soft markets are where you really need the strong and efficient management.

I have attached an example to this post that illustrates a potential "Value Add" deal. Some of the key points to highlight.

  • The rent loss and repairs are factored into the loan
  • The loan will likely be a "bridge" type loan.
  • The interest rate will be higher that that of a stabilized property.
  • Value by lender is detemined to be higher than the All-In cost.
  • Year 2 the interest rate drops as a refi is targeted.
  • The Upgrades/Rent loss section assumes 200K held by the bank to fund repairs and rent loss.
  • The cap rate will likely be low and in this example it is under 4% on the purchase.

Again, I put this example together quickly. Any potential errors or questions are welcome.
 

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Last edited:

JScott

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Steve,

Because I can't see your actual spreadsheet calculations, it's hard to figure out how exactly the "Total Return" value is being calculated. But, it seems about $200K high for the Year 1 and Year 2 lines, so I was wondering if you had forgotten to deduct the $200K in upgrade costs from that calculation (or am I missing something else)?

Seems like the Total Return in Year 1 would be:

New Price - Original Price - Upgrade Costs + Cash Flow + Depreciation + Tax Benefits = Return

$1.04M - $650K - $200K + $18K + $13k + $4K = $225K

Still a damn good return though!!! :)
 
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SteveO

SteveO

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Thanks JScott,

I really appreciate the eyes on the math.

This is all going to come together in another post.

Feel free to keep looking for mistakes. I am taking parts of spreadsheets and making modifications to them. This is a bit prone to errors.
 

phlgirl

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Thank you for taking this time to post these examples, Steve. I will not claim to understand it all but I definitely feel like I am learning. +++++

Ironic, to me, that you posted this example for the value add. A friend/fellow investor of ours recently came to us with a very similar deal. It is a 24 unit building, with a distressed seller - who boasts 96% occupancy and claims no salary expense for maintenance, etc. There is a 5% management fee.

Not knowing much about Commercial RE, I would say that the neighborhood is a solid rental market. It is close to public transportation, in a densely populated area, with a stable renter base. That said, I don't necessarily think that the area is poised for growth. In fact, I would say that it might be near maximum capacity.

Would you ever think it wise to invest for one or the other (value add or growth) but not require both?

Hope this makes sense. I realize it is hard to say without all the facts.

Thanks again!!
 

MJ DeMarco

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Great write up Steve ... Speed rep++
 
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SteveO

SteveO

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You always need to factor in maintenance. A smaller property begins to get difficult on the staffing since it won't support full time staff. If the management company can't staff the office with a leasing agent, they will probably charge more like 10%.

I like to get both the value add and growth. It allows for more room in potential pitfalls.
 

Bilgefisher

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Steve,
Thanks for the post, looking forward to future posts.
++
 

Ultra Magnus

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The "Warren Buffet" approach to RE returns, interesting read @SteveO! I'm not in RE but I figure it's good to keep this kind of stuff at the back of one's head since it's a great avenue for future investments.

EDIT: There are many posts from the olden days of the forum prior to introducing likes that are criminally underrated!
 

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