The purchase of a piece of multi-family investment real estate is not like purchasing a bond where it is easy to see the rate of return. The CAP rate displayed on the listing only tells a part of the story. Other factors, such as the quality of existing tenants and hidden expenses, can have a big impact on the realized returns. Today we are going to talk about value-add, actions the owner can take after purchase to increase returns and appreciate the property for future sale.
We first want an accurate look at the current operating picture and condition of the property. This is not only to assess the correct existing CAP rate, but also to find opportunities for improvements to the performance of the investment.
There are two main ways to change the existing situation: operational enhancements and capital improvements.
Operational enhancement opportunities are often found in under-managed properties and usually require little capital investment. Rents below market levels can be raised for existing tenants according to the Ontario Rent Increase Guideline(*1). When unit turnover occurs, rents can be raised to the market level for new tenants. On the other side of the balance sheet we can look for ways to reduce the expenses for the property.
Capital improvements are expenditures designed to improve the desirability and potential income of a property. Usually these are interior improvements to units since these have the most direct impact for tenants. Kitchen and bathroom upgrades tend to be popular. When considering capital improvements we should evaluate them based on how much extra rent can be charged compared to the cost of the upgrade.
A consideration that is often missed with value-add investing is the effect that a building upgraded and operating at its maximum potential can have on potential buyers if we intend to sell the property after some period. Buyers will often be evaluating the property in a similar way and we want them to be able to see potential to add their own value. For instance upgrading only some of the units and being able to demonstrate the increased income from those upgrades to buyers gives them a clear path to realizing their own value-add.
I have clients who take a very formulaic approach to this kind of real estate investing. They purchase properties with the intention to do the same value-rich upgrades to each of them. Having a relationship with a reliable contractor to do these improvements allows them to accurately know the cost for the upgrades before the process begins.
Value-add investment in multi-family properties is reliant on market awareness, accurate property evaluation and formulation of strategic plans that provide good ROI for expenditures. I am often able to leverage my local experience and relationships to help my clients find properties with big potential for value-add investing.