Commercial Real Estate: Beating a Real Estate Market Downturn

Written by Posted On Monday, 25 March 2019 09:50

Before the housing crisis, a majority of real estate investors didn’t believe a crash could happen. In fact, even when alarms were sounded, most continued on as if the market would continue to expand. This led to substantial losses. However, it also led to a new understanding about real estate and provided a strategy for growth even during a market downtown. This strategy is known as value-add multifamily investing.

What is Value-Add Investing?

Value-add investing is not the only way to make a profit, but it is a good way to maintain stable returns, even when the market is down. To do a value-add investment, you first need to buy a property that has an easy-to-calculate ROI. Then you improve the property to increase the ROI.

How is this done? By looking for problems with the property that keep it from reaching its highest potential and then fixing those problems. Doing so brings up the rent as well as the property value.

130-Unit Value-Add Example

To truly understand value-add multifamily investing, it might be helpful to see an example. We recently purchased a property built in the 1980s in a small college town. The property had the following characteristics:

  • 130 units
  • Most units needed heavy updates and remodels
  • Average rent was $729 per month
  • Vacancy rates were low because of college students
  • New multifamily units in the area rented for $1200/month
  • Updated multifamily units in the area rented for $850 to $950/month

When looking at the comps, we realized that the repairs made by the updated properties included lighting, appliances, flooring, countertops, and cabinets, as well as landscaping. The cost to make these updates would be $5,500 per unit with projected rent increases of $100 per month.

To determine if this property was a good value-add investment, we first looked at the cap rate, which is the ROI. This is calculated by dividing the net operating income minus any debt service by the purchase price of the property. The cap rate was 7%. Since the NOI was $545,000, the purchase price should be $7.8 million.

To calculate the ROI, you divide the cost of upgrades by the increase in rent for a year. That would be $5500/$1200, or almost 22%.

Now, we looked at the new gross income on the property, which was $829 x 125 units (assuming a few units were always vacant) x 12 months. This equals $1.243,500 minus the operating expenses, and you get $698,500. Using the 7% cap rate, the property value would now be $9.98 million, $2.2 million more than the original purchase price and $1.5 million more when you take into account the expenses incurred for upgrading.

Selling a Value-Add Property

If this is such a great strategy, you might be wondering why owners don’t do this themselves rather than sell the property to you. There are many reasons. Here are just a few:

  • The balloon payment is coming up and the owner will not have enough time to make the changes.
  • The owner does not have the capital to start the upgrades.
  • The owner does not feel comfortable with large-scale renovation projects.
  • To remodel, units have to be empty. The owner may not be able to handle the vacancies. If they want to sell in the near future, they may also not want to take the hit on the value of the property which happens when a property is not performing at 100% occupancy.

A Few Last Tips

There are a few things to keep in mind when using the value-add multifamily strategy for investing.

  1. If the property is significantly below market standards, repairs may not raise the rent enough to make a big difference in the ROI.
  2. Not all upgrades increase rents. Be sure to consider your potential tenants. Add upgrades that will bring in renters that are willing to pay the higher rents.

To learn more ways to add value to your RE investment portfolio head over to the REKI Commercial Investment Library.

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John Trautman

John Trautman has spent his entire adult life in real estate. Purchasing his first property at 23, he learned the process of flipping and real estate holding from the ground up. Real estate continue to be his passion while he spent eight years as an account executive and later a vice President for Washington Mutual in the mortgage division. Holding the position of President’s Council and several years of President’s Club, he learned the lending business from the mortgage office perspective and lender perspective. Throughout his life he has also been a small business owner, commercial real estate holder, property designer, and house flipper.

During the downturn, John followed the deal to Detroit, Michigan, where he invested in single family rentals and multi-family dwellings. Once his returns were realized, he moved quickly to Arizona to invest in another distressed market.

His passion for making a deal and real estate has lead him to create a hands-on real estate investment mentoring club called Real Estate Knowledge Institute

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