Rod Khleif Real Estate Investor, Mentor, Coach, Host, Lifetime Cash Flow Through Real Estate Podcast.
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Broadly, there are three popular commercial multifamily investment strategies:
1. Yield or turnkey: With a yield or turnkey strategy, an investor purchases a multifamily property that is already in good condition with positive cash flow. There is little to be done beyond implementing strong management practices and monitoring monthly rental collections. This is a relatively low-risk strategy that tends to provide stable returns over time.
2. Distressed: A distressed strategy is the exact opposite of the yield strategy. A distressed buyer actively looks for properties that are run down, in poor financial condition or otherwise poorly managed. Through a combination of financial investment and operational expertise, they bring the property back to market standards and charge market rents. This is a high-risk strategy that can deliver boom/bust returns.
3. Value Add: A value-add strategy is somewhere between the yield and distressed strategies in terms of risk. A value-add investor is one who looks for a good property with below-market rents in a good location that is in need of relatively minor repairs or renovations. Through a combination of physical renovations and efficient management practices, they are able to “add value” to the property over time. Typically, a value-add strategy provides a return in the form of both income and capital appreciation.
In my classes and personal investment business, I advocate for a value-add strategy and have had a significant amount of success with it. One of the tricky parts about using it is that an important decision has to be made about exactly what repairs and renovations to make. The question that all value-add investors have to ask themselves is, “What amenities/renovations should I add that will give me the most bang for my buck?” In other words, which types of renovations will allow you to increase rents the most to pay for the cost? We call these winning amenities.
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Unit Amenities Versus Community Amenities
When considering which potential renovations/additions will add the most value, it is helpful to think about them in two buckets: unit amenities and community amenities. As their names suggest, unit amenities are items or finishes that are added to each individual unit to justify a higher rental price, while community amenities are items that are added to benefit the community as a whole (while also justifying a higher rental price). The National Apartment Association in 2017 published a white paper that sheds light on which types of amenities offer the best return on investment.
At the individual unit level, washers and dryers are by far the most common unit amenity that owners chose to add or upgrade, followed by high-end appliances (particularly in the kitchen), hardwood floors, lighting and energy-efficient appliances. Each of these options presents an opportunity to increase the rent because tenants are willing to pay a premium for them. For example, in the survey, 49% of tenants said they would be willing to pay a $75-per-month (on average) rental premium for hardwood floors, while 41% were willing to pay a $50-per-month premium for a balcony, and 39% were willing to pay a $30-per-month premium for granite or solid-surface countertops. When this premium is multiplied over many units and many years, the income increase can be significant.
At the community level, the story is the same in that there are some amenities that residents are willing to pay a premium for and some that they are not. Per the same report, fitness and wellness-related amenities are the top items that residents are willing to pay more for. In fact, 46% of respondents stated they would pay a premium for on-site fitness classes, while 42% said they would pay a premium for access to walking trails and running tracks. The actual rental premium for fitness amenities varies by city. For example, those surveyed said they would pay an average of $66.94 more per month in Boston, but only $10.57 in Denver, where access to outdoor recreation like hiking and skiing is plentiful.
Other popular community amenities survey respondents said they would pay extra for include pet-friendly zones and coworking spaces, a feature we have seen increase in popularity during the Covid-19 pandemic.
Amenity Cost-Benefit Analysis
Adding any unit or community amenities represents a cost to the property owner, so it is important to understand the relationship between the cost of amenity itself and the potential benefit gained from it, meaning the rental premium. In my investment business, the general rule of thumb is that the capital expenditure associated with the amenity should be recovered within 36 months through rental increases.
To illustrate, assume that a value-add property is purchased, and a plan is established to make the following renovations/additions to each unit: new appliances, hardwood floors, lighting upgrades, solid-surface countertops, washer/dryers, ceiling fans and garbage disposals. The total cost of these updates is $7,946 per unit.
To earn back this cost within 36 months, the rent for the renovated unit needs to increase by at least $221 per month ($7,946 divided by 36 months ). But, this isn’t the only consideration. This rental increase needs to be supported by the local market, which means that the post-renovation rental prices must be achievable in the local market.
Conclusion
The basic premise behind a value-add multifamily investment strategy is to buy an existing property whose rents are below market and to renovate or repair it by adding in-unit and community amenities that command a rental premium. Generally, energy-efficient appliances, hardwood floors, high-end kitchen appliances and solid-surface countertops are the most popular individual unit amenities. Fitness facilities, pet-friendly areas and coworking space tend to be the most desired community amenities.
Deciding which amenities to add is a function of renter demand, local market dynamics and proven research about how much rental premium each amenity can command. To best meet the needs and demands of your prospective tenants, invest time into your market research, and choose wisely.
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