As investors in multifamily real estate, we have to weigh and measure a variety of different variables when judging a new investment opportunity. When you’re new, it might seem a little daunting. There are a lot of different perspectives out there and sometimes it’s easy to get overwhelmed. Perhaps you’ve been in the real estate game for some time now, but you still feel like there are gaps in your knowledge that you’d like to fill.
The place where we can all benefit from continually sharpening our pencil and improving our skills is in underwriting and analysis. The better you are at analyzing markets and stringently underwriting deals, the higher your performance will be in the multifamily space. There’s a lot of competition out there and if you’re operating on a half-complete understanding of the market, you’ll end up overpaying or being misled by inaccurate projections.
The goal of today’s article is to give you some of the most effective, hardest-hitting analysis and underwriting tips and techniques we use in our own business. There are no magic bullets in investing, but having the right tools in your tool belt will allow you to invest with confidence.
1. Look at Return on Cost for Value-Add Deals:
If you’re a passive investor in multifamily syndications, you’re probably familiar with the value-add strategy. Many real estate investment companies like ours go after properties that have below market rent, but could achieve significantly boosted rent from renovations. By renovating and improving the property, you add value. When done properly, you add much more rental value to the property than you spent on renovations.
The strategy itself is simple enough to understand, but the problem lies in that many people don’t know how to easily quantify the amount of value they would be adding when analyzing a deal.
The first step is to get an idea of what the market rent for renovated properties near the asset you are analyzing. Then, you subtract your current rent from that market rent to get an idea of the rental increase you will achieve post-renovation. For example, if your units are renting for $900 a month, but the market rent you could achieve post-renovation is $1000, then you know your projected increase is $100 a month, or $1200 a year.
Next, you need to know your per-unit renovation costs. This is obtained by getting estimates from your property management company or general contractors in the asset’s market. Let’s say your renovation costs are $4500 per unit.
Once you have all that, you can look at your return on cost on a per-unit basis. Simply divide your annual rent increase for that unit, in this case $1200, by the renovation cost for that unit, which is $4500.
Return on Cost = Annual Rent Increase Per-Unit / Renovation Cost Per-Unit
$1200 / $4500 = 26.6% return on cost
We tend to only shoot for investments where we can achieve a return on cost of 20% or greater. This justifies our time and energy to locate these deals and then manage the renovations.
2. Look at New Capitalized Value for Value-Add Deals:
Another way to analyze value-add deals is to look at the capitalized value of the incremental revenue you’re adding. We use the same annual rent increase per-unit that we used in point one for this as well. Since these are renovated units, we would expect that there would be no increase in expenses or even a slight decrease. This means that our renovated units just add additional revenue to our NOI, and we don’t need to factor in new expenses into this calculation.
Looking at it from this perspective, you simply take the annual rent increase you expect to achieve per unit, then divide that number by the going cap rate for multifamily assets of the same class within you market. This number will show you the amount of value in dollars you have added to the unit for your renovations.
Let’s say that our example from earlier is a multifamily asset in a market where similar properties are trading at a 5% cap rate.
$1200 annual rent increase / .05 market cap rate = $24,000 increased value per renovated unit
Next, you subtract the cost of the renovations for the unit to find the equity created through your efforts.
$24,000 increased value – $4,500 renovation cost = $19,500 in equity created
TIP: Aim for at least $100 in per-unit monthly rental increases per $5000 in per-unit renovation costs.
3. Quantify the Value of Amenity Spaces by Comparing to Market Averages:
When it comes to amenity spaces for multifamily investors, we’re often just looking to up our game to the level of the competition. It’s difficult to quantify the per-unit rental bumps you would be getting from these improvements, so the best you can do is just keep up with the Joneses and make sure your property has all the same bells and whistles as its peers.
Even if you can’t put a dollar value on the amenity spaces, you still need to ensure you aren’t providing less than the other apartments your prospective tenants will be considering. Typically you will conduct a market survey to inform a detailed list of what kind of amenities are expected within that market.
TIP: Get creative with where you can add value for your tenants while creating additional revenue streams for yourself. If your property is zoned to allow mixed use development, you could add a gym or coffee shop, for example.
We try to take it a step further than that in our own analysis. Remember with amenity spaces, you should try to look at total revenue gain as opposed to just simple rent increases. Benefits can come in the way of increased occupancy due to your property being more desirable to live in.
One way to attempt to quantify the amount of value added by your amenity spaces is to compare the occupancy and year over year rental rates in the market for comparable properties to your building. If your occupancy is trending higher and your rental rate grew more quickly than the market, you can get some idea of just how effective adding amenity spaces have been in boosting your returns.
In a typical value-add multifamily deal, you won’t be renovating all of the units – usually only some fraction of the total amount, say 70% of the units needing renovation. To get an even more accurate idea of the value added from your amenity space, compare the market annual rent increase to the rent increases you were able to achieve on the 30% of units you didn’t renovate to get an apples-to-apples comparison.
If the units that didn’t need renovation still outperformed the market in rent growth or occupancy, you can start to hone in on what other factors might be influencing your success, such as your amenity package.
4. Focus on Economic Occupancy as opposed to Physical Occupancy:
We’re all familiar with physical occupancy. This is simply the percent of units that are physically occupied with tenants. It should ultimately be your goal to have high physical occupancy, but 100% occupancy is meaningless if you were only charging $1 a month in rent, to give you an extreme example that illustrates the concept. It might seem counter-intuitive at first, but 100% physical occupancy can often be a sign of mismanagement because the rents are well below market value.
Furthermore, in the multifamily space, it’s extremely rare to find habitable properties with severely low physical occupancy. Even incompetently managed properties will likely be north of 80% physical occupancy and properties that dip below this level likely have some kind of severe issue beyond mismanagement.
TIP: A typical multifamily asset in a competitive market will have 50-60% turnover per year. If executing a value add strategy where leases are renovated as they turnover, it will typically take around 2 years to complete renovations.
This is why you should be more concerned with your economic occupancy. Economic occupancy measures the percentage of the property’s gross potential income that was earned. In other words, you calculate what the property would earn if all units were rented out at market rates, which is your gross potential income. Next, you divide the actual gross rental income achieved at the property by your gross potential income. The percentage shows how your property’s performance measures up to its true potential.
Economic Occupancy = Gross Rental Income / Gross Potential Income
Your main concern is in boosting this number. If you haven’t properly set your focus on economic occupancy as an important metric, you might begin viewing deals with high physical occupancy as not worth your time because there isn’t enough meat on the bone for you to add value. This couldn’t be further from the truth. In fact, we’ve found that sometimes the best deals are ones with high physical, but low economic occupancy at the time of our acquisition.
TIP: Remember that achieving 100% economic occupancy is unrealistic. Shoot for around 90%, as that is a typical level for a healthily performing multifamily asset.
5. Begin your Analysis on the Market:
While most multifamily investors are interested in selecting high-performing markets, I’ve noticed that there is often a lack of attention focused to analyzing markets themselves as opposed to just underwriting individual deals. Investors have a tendency to settle on a few markets and hunker down without much further analysis.
We put a special emphasis on keeping a pulse on market conditions. The most important factor we look at is employment as jobs drive everything from tax revenue to appreciation due to gentrification. You want not only strong employment, but economic diversity to prevent against a calamity if an industrial pillar of the economy becomes obsolete.
You should also pay special attention to the area’s infrastructure. What is the quality and state of the area’s schools? Are there economic anchors like hospitals nearby?
Another important thing to pay attention to is the political reality in the market. If the area is growing, it can be enhanced or hindered by politics. How do the local politicians respond to NIMBY (not in my backyard) complaints? Are they unrolling infrastructure upgrades and additions that scale with the increase in population?
Finally, you should pay attention to the amount of dollars being invested into the market. A high cap rate deal might look nice on paper, but might not feel so nice when you go to sell and find there aren’t any buyers looking to enter that market. We ultimately shoot for a balance by focusing on strong secondary markets that act as satellites of extremely competitive markets.