By: Norman Radow, The RADCO Companies
Five years ago, I toured a 1971 vintage unrenovated deal we recently acquired. We had just delivered our first renovated apartment. The renovation boasted new flooring, resurfaced cabinetry, new appliances, vents, switch plates, and safe wiring. We also added GFI circuits to the kitchen and bath. Although a vast improvement, many of the new finishes posed problems.
There were issues with the materials applied. The walls were wavy and had uneven paint applications from 41 years ago. The floors had noticeable sags, which I likened to wearing spandex. The vanity no longer fit because the walls were not straight. I complained to my project manager with a litany of objections.
Duh! We were not renovating the unit for me, but for our demographic. We needed to give our tenant the highest quality product for the price, because working class housing has different priorities. I needed this “aha moment”, because I had no precedent to follow. No one had made this “value-adding to older multifamily stock” a business…yet.
For decades, the garden apartment industry was predictable. Institutions owned new communities for 15 years, then sold them to Class B owners, who would allow them to age over time. Thus, the older properties became the affordable option for working class renters. A decade later, the property would be sold to a Class C owner who would focus on the entry-level workforce and perhaps Section 8 tenants. Repairs and improvements would be minimalized and the community would be managed literally into the ground, resulting in a sale for its land value. Wash, rinse and repeat, as every cycle looked the same….until now.
Just a few years ago, an entirely new industry was created. A new type of buyer of Class C and B multifamily entered the fray, displacing the older type owners who just babysat their properties and were crushed in the Great Recession, including RADCO, who recognized that a dramatic, precedent-setting series of demographic, economic and social changes was causing America to become the “renting nation”. Our goal, also a first, was to reset the economic clock of older housing stock, provide a better living experience, and satisfy an immense demand by the millennial demographic and the much larger American workforce population.
As I learned with our first renovation, reinventing an industry is not easy. In most cases, the renovation work must be done in an occupied community. To pivot a property successfully, a higher level of upgrade may then be needed to capitalize on the higher rent-paying tenants we have attracted.
There are three basic strategies for value-added developers. One plan positions the community for the long haul so that the construction project can be efficiently staged. Another plan is to reset the economic clock on some systems and call it a day. There is a third alternative. It’s a hybrid of the first two plans. This plan includes tackling life safety systems, providing for transformative critical path and amenity improvements, and allocating funds to renovate no more than 50% of the apartments over a two-year period. Under this plan, the developer needs to raise far less expensive equity, can experiment with different unit scopes to test the market, and then can ratchet them up or down as the market and the ROI (return on investment) dictate.
A value-added plan can succeed even without a unit upgrade program, because the addition of better amenities, quality of life improvements, and newer systems can generate enough of a return without it. In fact, in every case where a unit upgrade program was suspended, it could be re-established a year or two later when the tenancy and market further improved. This plan offers incredible flexibility. Also, changing a scope later can provide a newer rent trend that can be used to justify a more favorable capital event at the appropriate time in the ownership cycle, which could include a sale to another value-added buyer who will pay a lower cap rate for an easy-to-justify capital expenditure play. Or, it could allow one to use cheaper debt dollars to complete the work in lieu of more expensive equity.
However, this requires a nimble and very strong corporate infrastructure, is challenging to manage, and requires great discipline, such as when to stop upgrading. And then, when would you start again with a more sophisticated tenancy? A major concern is that a developer could run out of capital dollars before a refinance or sale becomes an option, such as surprises behind the walls or underground. How does the developer fill that gap? One respected Class A developer said to me, “I know this is the better plan. I know it can offer better returns. Yet, every time I begin to pursue a value-added strategy, I quickly give up because I realize it is too difficult.”
These strategies require active leadership, more sophisticated human resources, and a property management team trained in the process that can run a community, while it is under extensive renovation, which is not a simple solution. The value-added idea is still relatively new to most in the industry and the available workforce is neither trained nor experienced to manage through it, leading value-added developers to invest in new software, recruitment, and training methods. More are bringing this infrastructure in-house to bypass filters that third party infrastructure may exacerbate due to significant additions to the costs of the business.
In short, while the returns can be terrific in many ways, the value-added multifamily business is more challenging than it appears. It is, however, serving an urgent and fast-growing need by providing cleaner, safer, and more modern housing options that most Americans can afford. A small cadre of newcomers are creating new protocols, methodologies and industry-leading training and recruitment to build on the business. The new entrants into the business now have precedent and best practices to follow and proven ideas to emulate.
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