How to Start Investing in Value Add Multifamily Properties
Over the past few years, I have noticed that many successful real estate entrepreneurs and investors started their journeys investing in single-family homes and fixer-uppers.
Although many of these investors experienced early success in the single-family space, they soon found out that it is difficult to scale in residential real estate once you have a certain number of properties under management.
I attended an event earlier and spoke to a couple who currently own five residential properties.
They admitted that managing their current portfolio has become a second full-time job for them.
When I asked them how much cash-flow they are getting from their five homes, I was shocked by their response.
Less than $1000 per month.
In Calgary, the average home is anywhere between $400,000 - $500,000. If we assume that this couple is putting down 25% on each of their homes, then we can reasonably infer that they have roughly $500,000 of equity in their residential portfolio.
They were receiving less than $12,000 per month from half a million dollars invested.
If you do the math, that is less than a 2.5% ROI.
To me, that is not a great return on your capital.
Fortunately, this couple already knew that they had a problem. When I asked the couple how they planned on solving this problem, they told me that they were exploring the idea of investing in multifamily real estate.
This desire to move beyond residential real estate and invest in multifamily real estate was also common amongst my coaching clients.
Many of my clients started as residential real estate investors but eventually grew weary of the paltry returns and the long hours associated with managing several single-family properties.
They were telling me that they want to generate enough passive income to replace their current jobs.
Although my clients enjoyed their current profession, they wanted their real estate portfolio to generate enough income so that they could walk away from their jobs if they decided that they no longer wanted to continue working.
In my experience as an investor and developer, I find that it is difficult and increasingly rare for highly paid professionals to achieve true financial freedom by strictly investing in residential real estate.
If my clients truly wanted financial freedom, then they were going to have to think bigger than single-family homes and fixer-uppers.
Below is a video where I interviewed Beau Beery - one of the top Multifamily Brokers in the US
The Problem with Residential Real Estate
Not only is it challenging to scale residential real estate from a management standpoint, but the probability of generating outsized returns in residential real estate is substantially lower because residential properties do not trade on an income-based multiple.
More often than not, residential properties are bought and sold based on recent sales of comparable properties in the vicinity.
Because residential properties are traded on a comparable sales basis, taking steps to increase the net operating income of a property does not necessarily translate into a higher valuation.
This naturally places a ceiling on the profit potential of each residential deal.
For example, let's assume that you buy a residential property and convert the unfinished basement into a basement suite. This new basement now generates an additional $800-$1000 in rent every month.
The problem is that the property's value does not correspondingly increase in relation to the additional income that the property generates.
Instead, when it comes time to sell the property, a residential broker will provide you a list of comparable homes in the area that include a finished basement suite.
The resultant profit ceiling that follows from the industry-wide adoption of the comparative sales valuation naturally minimizes the possibilities for residential real estate investors to generate outsized returns and build true wealth
Furthermore, it creates ambiguity and uncertainty for investors that take a value-add approach to real estate investing.
Why Invest in Value Add Multifamily Properties?
Unlike residential properties, apartment buildings are bought and sold on an income-based approach. In simple terms, the more income a property generates, then the higher the valuation.
Since multifamily real estate is traded on a multiple of how much income the property generates, any small increase in revenue or expense can drastically change the valuation of a property.
This enables sophisticated investors to build true wealth and generate outsized returns by investing in mispriced or mismanaged assets.
Lesson #3 – Do not invest on emotion
The unfortunate reality is that my parents and I followed the herd and got caught up in the moment.
We saw a group of wealthy businessmen in our town invest in an opportunity and thought this could be our chance to get ahead.
We did not want to miss out.
Without any due diligence or prior research, we blindly trusted my boss and then lost it all.
After that event, I vowed I would not let that happen to anyone around me again and spent several years learning how to evaluate and manage risk. More importantly, I learned how to manage my emotions when investing.
As an investor, there is nothing worse than getting greedy and experiencing FOMO – i.e. the fear of missing out.
One Simple Strategy For Creating Outsized Returns in Multifamily
To illustrate this point further, here is a simple example.
Property A is a 10-unit apartment building located in a working-class neighborhood in Calgary. Property B is also a 10-unit apartment building located in the same area as Property A. Both properties have identical tenants and are of similar vintage. However, Property B's owners have poorly managed the apartment and have not increased rents since 2016.
As a result, the net operating income – the income generated by a real estate investment before debt payments – for Property B is lower since the rents for that property are lower than Property A.
In these types of situations, a sophisticated investor that recognizes the below-market rents for Property B can acquire the property, improve operations, and subsequently raise rents.
If executed correctly, an investor can significantly increase the value of Property B.
Here is a rough breakdown of how this would work:
Assume that the investor purchases Property B for $1,000,000.
The net operating income for this property is $50,000 per year and the rents for this property are $100 below the current market rates.
In this case, the investor purchased this building at a 5% cap rate.
A cap rate is a term used to measure the unlevered yield of a property.
In simple terms, a cap rate measures how much yield a property would generate if you were to buy it without any debt.
In this case, if the investor were to purchase the entire building for $1,000,000 with no debt, then he would generate $50,000 of income, which is a 5% unlevered yield.
The formula for calculating a cap rate is as follows:
- Cap Rate = (Net Operating Income / Price) * 100.
- Cap Rate = ($50,000 / $1,000,000) * 100
- Cap Rate = 5%
Just to recap, here are the facts you should know about Property B:
- Purchase Price: $1,000,000
- Units: 10 units
- Price/Unit: $100,000 per unit
- Net Operating Income: $50,000
- Cap Rate: 5%
- Rents: $100 below market
Upon acquisition, the investor decides to move forward and raise rents by $50 per month on all ten units.
This would generate an additional $500 /month in revenue.
On an annual basis, that would be an additional $6,000, which would increase the net operating income from $50,000 to $56,000.
An increase of $6,000 in net operating income translates to a $120,000 increase in value at a 5% cap rate.
Here is how we got $120,000.
- Net Operating Income (after $50 rent bump): $56,000
- Cap Rate: 5%
- New Valuation = Net Operating Income / Cap Rate
- $56,000 / 5%
- = $1,120,000
Now I know what you’re thinking…
"Shane, you didn't even account for the costs associated with renovating and subsequently turning over the units!"
That’s a valid consideration.
Depending on the market and competitive set of properties, some sort of capital expenditures may be warranted – especially if the property has been poorly managed by the previous owners.
Let’s say that the cost of turning over and renovating each unit is $5,000 per door.
With ten units, that would equate to $50,000.
Upon completion of each renovation, each new unit would now rent for an additional $100 per month.
Since property B has 10 units, this would equate to an additional $1,000 per month in rent.
This would result in an additional $12,000 in annual net operating income.
Assuming a 5% cap rate, the additional $12,000 in net operating income would result in the value of the property to increase by $240,000.
By investing $50,000 in capital expenditures, a sophisticated investor can create $240,000 of value in this property.
To recap, here is how to Add Value to an Apartment Building
Review of the Numbers:
- Number of Units: 10
- Renovation Cost Per Unit: $5,000
- Total Renovation Cost: $50,000
- NOI Before Renovations: $50,000
- NOI After Renovations: $62,000
- Cap Rate: 5%
- Post-Renovation Value: NOI After Renovations / Cap Rate
- $62,000 / 5%
Upon completion of the renovation, an investor can either choose to sell the property upon realization of the business plan or partially draw upon some of this newly created equity via refinance and then look for similar opportunities in the market.
Although the investor might not be able to pull out all of the newly created equity upon refinancing the property, let's assume that the investor can secure a new loan at a 70% Loan to Value ratio (LTV). A new mortgage at 70% LTV would allow the investor to pull out $168,000 of equity.
This is how this would work:
- New Valuation: $1,240,000
- Loan to Value Ratio: 70%
- New Loan Amount: $868,000
- Previous Loan Amount: $700,000
- Proceeds from Refinance = New Loan Amount – Previous Loan Amount
- $868,000 – $700,000
- = $168,000
Alternatively, if an investor wishes, he could utilize the withdrawn equity to later invest in a headache-free, stabilized property that produces income like clockwork.
In summary, identifying and acquiring mismanaged or mispriced assets, and then implementing a business plan to rectify operational issues and/or increase top-line revenue is the hallmark of value-add commercial real estate investing.
These strategies for creating asymmetric, outsized returns are what many sophisticated real estate investors utilize when acquiring multifamily properties. Regardless of the asset class, increasing a property’s net operating income is a proven strategy for creating wealth in commercial real estate.
Takeaways for New Multifamily Investors:
- For many residential real estate investors, managing their portfolio becomes a second full-time job.
- More often than not, the returns do not justify the amount of time and energy it takes to manage a small portfolio of single-family homes.
- For high-income professionals looking to build enough passive income to replace their day job, investing in residential real estate is not the best way to do so.
- Because residential real estate is traded on a comparative sales approach, the probability of an investor making outsized returns is usually low.
- This ceiling on profits combined with the management intensity associated with owning several single-family homes makes investing in residential real estate non-scalable.
- Unlike single-family homes, multifamily real estate is generally bought and sold on an income-based approach.
- Since multifamily properties are traded on an income-based multiple, a sophisticated investor can employ several strategies to capitalize on a mispriced or mismanaged asset in the marketplace.
- As demonstrated through our previous example, raising rents by $100 on a small 10-unit building can be enough to increase a property's value by $240,000.
- These kinds of outsized returns are further amplified by the fact that the majority of investors employ leverage when acquiring commercial properties.
- Even if you account for the costs associated with turning over and renovating a unit, a savvy investor can unlock tremendous amounts of value by implementing even modest renovations.
- Regardless of the asset class, increasing a property’s net operating income is a proven strategy for creating wealth in commercial real estate.
From flipping fixer-uppers to raising anywhere from $2,000,000- $9,500,000+ per deal and earning $100k-$200k upfront, I learned the commercial real estate syndication game through the school of hard knocks.
Over the years, I have been invited to many lunches and coffees to help other real estate investors scale their businesses, structure deals, raise money, and evaluate opportunities that they are finding. My 12+ years of experience in raising capital and commercial real estate investing has saved some of my clients from fatal deals.
It is such a loaded topic, that even a few hours of coaching was not enough to truly help them.
So, I started sending them long emails and documents with principles on how I invest in commercial real estate.
Eventually, those emails and documents were organized into a series of articles and videos, which formed the basis of the Commercial Real Estate Training Program – an 8 Week-long program designed for active real estate investors interested in investing in commercial properties.
By participating in this program, I can help you design your commercial real estate investing blueprint by showing you the exact systems and processes I use for my investments.
On the other hand, if you are a highly paid professional looking to learn more about commercial real estate, then check out my article “Why Many Highly Paid Professionals Have No Idea How to Retire” and go ahead and download my free e-book “Club Syndication” – which you can find here.
Shane has invested in commercial real estate since 2008 and personally completed multiple 8 figure deals. He’s currently a developer in Calgary AB, with multiple retail, industrial and multifamily/townhouse projects underway.
One of his favorite deals, was acquiring an 1,152-acre resort property just north of Toronto for $8.5M and turning it around and selling three and half years later for $17,000,000. It was not a smooth deal and things didn’t always go as planned. It worked out in the end, and it was this experience that gave him a real-world MBA in investing.
Commercial Real Estate Investing Scorecard
My 8 Non-Negotiables to Investing and the checklist for how I analyze every property