As a limited partner, you’ve heard the term “value-add” a few times by now. It’s probably the most overused term in multifamily investing today. If a property was built prior to 2020, there’s a good chance that the sponsor will label it as a value-add. But is it really though?
That term references the incoming investor’s opportunity to improve the property, grow its income stream, and increase its market value. This can be accomplished either through renovations and upgrades, operational cost reductions, or both. If executed properly, a combination of these implementations would result in an increase in net operating income, and a subsequent higher market valuation.
But just who is the “value” being created for? I ask myself this when looking at many of the recent offerings. Is it for the seller? Or for the contractors, brokers, lenders, lawyers, or any other vendor involved in the transaction? These folks are all going to make out just fine and find a lot of value in this market when they cash-out or provide their services. Worse yet, is it the sponsor using the asset to derive value for themselves through acquisition and asset management fees to support their lifestyle?
If you are the limited partner, YOU better be the one getting the value, as well as the residents of the community you’re investing in!
In today’s market, it’s not uncommon for a property to be on its fourth or fifth value-add cycle. Each sponsor takes a crack at making some improvement or simply rides the appreciation wave for a year or two, and then tries to convince the next potential buyer that there’s a proven plan that just needs continued execution to add to the already lofty market price.
So, how are the limited partners to know whether there’s really any meat left on the bone in a deal?
It comes down to the scope of the project, understanding a few key metrics, and applying them to the specific market and asset class in question. The following are the questions I ask when evaluating a value-add deal.
What is the asset class?
What class of property are you underwriting – A, B, C or D? The location, age, condition, and operational status of the property are all going to dictate its class and, ultimately, give you an idea of the scope of renovations and upgrades needed.
What is the market cap rate for the class of property in the specific market?
Here in Indianapolis, for example, Class A new construction is trading at sub-5-cap prices. Class C is trading closer to a 6-cap. Knowing the market you’re investing in and understanding what other properties around your potential investment are trading for is paramount. Verify this beyond the offering documents.
What is the yield-on-cost?
With the information above, you can take it a step further. You have heard of the big three metrics that are advertised on every deal – IRR (internal rate of return), cash-on-cash return, and equity multiple. Lesser published is the yield-on-cost metric. Yield-on-cost is extremely useful to begin to measure a potential value-add project’s viability. When calculating an in-place cap rate on a value-add project, you divide the current net operating income by the purchase price. But what if the deal has a $400,000 renovation budget that will result in higher rents? That cap ex budget is not accounted for in the sale price of the property. Yield-on-cost will, however, take this into account.
Example: A value-add project has an NOI (net operating income) of $120,000 and a purchase price of $2,000,000, which comes out to a 6% in-place cap rate at acquisition. The operator injects $400,000 to update the property, which brings the total project cost to $2,400,000. The improvements allow for higher rents and lower expenses, bringing the NOI up to $200,000. This results in a yield-on-cost of 8.33% (YOC = pro forma NOI / Total Project Cost ($200,000 / $2,400,000)).
What is the development spread?
Having this knowledge is critical as a point of comparison between yield-on-cost and the market cap rate for the specific asset class in question. This difference is called the “development spread.” In the example above, if the market cap rate was 7%, with a yield on cost of 8.33% (a development spread of 133 basis points), you can be confident that the renovations are leading to actual value to you as an investor. The higher the development spread, the better. Notice that the in-place cap rate of 6% differs from the 7% market cap rate in the example. The acquisition will be at a premium for the upside potential you gain, but the sponsor group should not be paying so much for it that the development spread gets wiped out.
Sometimes it’s worth taking a step further if there are some operational implementations that are relatively easy to execute. For example, let’s say the seller is paying 4% for property management and your sponsor has a great management team that can implement your plan for 3% on day one. By calculating NOI using trailing effective gross income minus stabilized expenses (the projected expenses), you can look at the development spread from a different lens – one that just measures the value created from the renovations and updates planned. This tweak can potentially better measure the effort and sweat equity required for the sponsorship team to get the desired outcome and exclude the low hanging fruit.
How do they weigh risk-adjusted returns with the scope of the project?
Now that you’ve got some data, there’s a qualitative component that enters the equation – is the risk and scope of the project worth the upside potential? This is all in the eye of the beholder.
If the deal is a light value-add, 2015 build, that just needs some paint and a few amenities to achieve a rent bump, maybe a 50-basis point development spread is going to provide a solid risk-adjusted return.
Alternatively, if it’s a distressed asset that is 70% occupied and will be a total reposition because it has a ton of deferred maintenance, 50 basis points isn’t worth the risk. Even if the project is executed perfectly, I’d argue interest rate risk could wipe out that spread through a cap rate expansion. It would be a real disappointment if you took significant risk in repositioning a distressed property, only to find out no value was added. For a big project like that, you may want a development spread of at least 200-basis points. Again, this is subjective, and the upside should be carefully weighed against risk.
Putting it all together
Here is how I calculate the future valuation of a property. I take the pro forma NOI (which I sometimes adjust if I think the assumptions are too aggressive) and divide it by two different multipliers, then compare those values with the total project cost:
- Current market cap rate for the property class
- Projected exit cap rate
The total project cost should be at a discount compared with the market and exit cap valuations. When calculating these, you will be able to see the dollar amount of the development spread and the equity being created through the “value-add” process.
Let’s go back to the value-add example discussed earlier in the post in Section “3”. In that example our pro forma NOI was $200,000. If that were the case, the following would be true:
*Market cap rate valuation at a 7% cap rate – $2,860,000
*Assumed exit cap valuation at a 7.5% cap rate – $2,600,000
*Total project cost = $2,400,000 (which resulted in a YOC of 8.33% and a development spread of 133 basis points).
This tells us, at project completion, if we were to sell in today’s market, our 133 basis point development spread would result in a net gain in value of $486,000 (not accounting for transaction costs). If we apply a reversion cap rate of 50 basis points (exit cap of 7.5%), we still have created $200,000 in equity, indicating the project has a buffer to withstand market headwinds, without giving back all the equity created through the value-add plan.
So, when you see or hear the term “value-add” in webinars, offering documents, and executive summaries, please approach it with a critical eye. The value-add potential should be reserved for the sponsor and investors. Get out your calculator, cut through the fluff, and apply your market knowledge to hard data. Numbers never lie, but they can be presented in a way that tells a story benefiting the storyteller. Underwriting is as much qualitative as quantitative. If you strip it down, you’ll be able to identify the true value-add deals and make the right passive investments – ones that balance upside and risk. Capitalize on those.
Paul Shannon is a full-time active real estate investor, as well as a limited partner in a number of syndications. Prior to leaving the corporate world, Paul worked for a medical device company, selling capital equipment to surgeons in the operating room. After completing a few rehabs employing the “BRRRR method”, he saw scalability and more control over how he spent his time, and left to pursue real estate in 2019. Since then, Paul has completed over a dozen rehabs on both single-family and multifamily properties. He currently owns over 50 units in Indianapolis and Evansville, IN and is a limited partner in larger apartments and industrial properties across the US. You can connect with him at www.redhawkinvesting.com
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