Through most of the last market cycle, value-add strategies offered compelling risk-adjusted returns to multifamily investors. In today’s market, achieving appropriate risk-adjusted returns in this space is often more challenging than acquiring newer, largely stabilized assets.
This article will break down what a value-add play is, what the challenges are in today’s market, and offer what we believe to be compelling alternatives.
Theoretically, value-add exists on a spectrum of increasing risk and associated expected return, and it traditionally falls between core-plus (on the lower end) and opportunistic (on the higher end).
Loosely defined, core-plus represent acquisitions of largely stabilized properties, with some upside potential through minor enhancements, remedying deferred maintenance issues, and finding operational efficiencies. Return expectations typically fall in the low- to mid-teens.
The opportunistic strategy is the highest risk category of real estate investing, and is defined by complete land development or other change in use (e.g. converting office to multifamily). Return expectations are typically over 20%.
Value-add strategies fall between these two, and typically include asset repositioning through physical upgrades to the property and/or marketing and rebranding efforts. The goal here is to keep the use of the property, but significantly increase the value by achieving higher rents, which in turn increases the property’s net operating income (NOI). Return expectations are typically mid- to high-teens.
The risks in attempting this strategy are worth exploring in more detail. These include, but are not limited to:
1) Budget overruns: whether units are renovated with tenants in-place – which adds its own challenges – or during a unit “turn” after a tenant vacates, the renovation timeline can take months to over a year to complete. In the meantime, the operator is exposed to potential cost increases in labor and materials, not to mention supply chain concerns.
2) Turnover and vacancy: If the renovation occurs during a unit “turn,” you need to account for downtime when the unit is unoccupied and not generating rent. Even if the renovation happens while the unit is occupied, the tenant may not renew their lease if they disagree with the post-renovation rents. As a result, there may be longer-than-expected vacancy before the unit is re-leased depending on the strength of the market.
3) Market potential: many operators talk about “forced appreciation” as if completing unit upgrades guarantees that the future income stream will be higher post-renovation. The market will always determine what is feasible. You may plan for a $200 lift in rents post-renovation only to find that new supply in the market limits your ability to achieve this.
4) Financing uncertainty: Perhaps most importantly, value-add deals are often financed with a short-term floating-rate bank loan. Here, you are not only exposed to interim increases in short term rates (as we witnessed in 2022-2023), but also a corresponding loss in valuation due to cap-rate expansion during the renovation. If you planned to refinance or sell the asset post-renovation, you may find unexpected and unfavorable capital markets when facing a looming loan maturity.
For these and other risk factors, investors should expect higher returns than if buying largely stabilized assets. We plan for, and pause, any renovation where we don’t realize a +20% return on invested capital in any given project.
The final factor driving our pivot toward newer, stabilized assets is the pricing spread compression in the transaction market between older and newer vintage products.
Years ago, it was common to be able to acquire ’70’s or ‘80’s-built deals at a material discount (premium in cap rate) compared to a newer asset. In today’s market, those spreads have compressed and it is increasingly challenging to find older products at an appropriate discount to newer assets.
With transaction activity beginning to pick up again, it will be increasingly relevant to check per-unit pricing compared to recent sales, as well as against per-unit replacement costs. As an investor, you should understand where your property fits in the rental landscape.
We believe multifamily does and will continue to offer compelling returns in terms of both cash yield and capital appreciation, but due to strategy risk and spread compression, newer assets are often more attractive at this point in the cycle on a risk-adjusted basis. Value-add strategies will continue to make sense when the market allows and such properties can be acquired at appropriate basis and discount to newer assets.
