How do you treat "deferred maintenance"?

Question

so every apartment deal if have looked at has considerable "deferred maintainance".

Is there such a thing as a turn key "c" class property?

Or, if it does not need considerable capex, is it then by definition a "B"?

I get that  a "c" has a higher cap rate in theory, because of age, location etc, but if i am paying for an 8% cap AND have 5 years of 25%(of gross) capex, am i the greater fool or should the price reflect the poor condition of all the consumable items and therefore sell at a higher cap rate?

Philip Williams · Answer

I'm amazed you actually found one with honestly stated expenses! Although to be fair the expenses are technically correct if they never do any maintenance. The worst I found was 10% of gross was the stated expenses, I'm sure you can guess how over prices that building was. Just for fun I ran my normal numbers and expenses were close to 48%

Michael Bishop · Answer

@Will Grabert I think that property grades are highly subjective and can't necessarily be tied directly to one or two factors. Property grade of course will have an affect on achievable rents, desirable amenities, etc, but will only have an affect on the CAP via the NOI, i.e. CAP is equal to NOI/price.

Deferred maintenance should NOT be confused with value-add opportunity and  any extensive deferred maintenance should lower the purchase price, thus increasing the CAP.

Bottom line is that if the costs incurred due to deferred maintenance squeeze your numbers, and the seller is unwilling to come down on price, don't try to tweak things to make the deal work. Just walk away and be patient, the right deal will come along.

James E. · Answer

@Will Grabert great discussion topic. Think in order to really dig in everyone should be defining "turn key" and "deferred maintenance" the same way.

Turn key to me means you can purchase the property and keep it running "as-is" over a reasonable period of time (3-5 years) without NEEDING any work (e.g. no safety / systems issues or something an insurance company would yell at you for), even if there are potential cosmetic upgrades.

Deferred maintenance I think of as things that need to be done that don't really provide a value add component and wouldn't command increased rent or help reduce operating expenses. New hvac systems, roof / structural repairs etc. are things you will need to fix but tenants won't pay extra rent for them.

So, yes, theoretically there are plenty of class C properties that have kept up with these types of things but may still have "value add" components that can be addressed through cosmetic unit / exterior upgrades as tenants turn over. The trick there is knowing what kind of upgrades to put in and not over do it based on the location and tenant expectations.

And yes, your offer price should reflect considerations for deferred maintenance.

Mike D'Arrigo · Answer

@Will Grabert Theoretically, the class of property doesn't have anything to do with the amount of deferred maintenance. It's quite possible to have A class properties with a lot of deferred maintenance. The problem with lower class properties and the reason that they often have more deferred maintenance is that with the lower price points, it's hard for a turn key company to do a higher end rehab. The numbers don't support it. It costs the same to put a new HVAC system in a C class property as it does an A class. This is the very reason that people buying cheap turn keys in low end areas should expect a low end rehab.

Henri Meli · Answer

Deferred maintenance is definitely an issue in "C" class assets, but not always. As many have pointed out, there are many other factors that go into it. Another thing people don't consider when talking about value-add is the quality of tenants you are bringing in. Better tenants keep your property better and therefore reduce the money you need to spend to turnover a room. When rebranding and repositioning, It is a good idea to really be picky about the tenants coming in.  If your turnover costs are consistently high, then you need to really work on improving the tenant base.

Will G. · Answer

Dorothy, i have only seen 1 property that honestly stated expenses, and that was from the management company(ended up being 52% of gross btw). So i  generally take the noi and offer $ based on 8 or 7% cap etc. My bank contends a "c" should be at least 8%, but may not be right for our recent, new reality!

So for instance, the deal with expenses from mgmt company, i did get the sale price way way down to an 8% cap but it needed $150k in flooring, a/c's, vanities, appliances etc,etc.

So does conventional wisdom, ask for price reductions, or just be happy with the 8 cap and make 0$ for the first 3 years?

I would like to hold long term, but also dont want to pay too much as that has never worked out well in the past.

Brad Shepherd · Answer

Deferred maintenance is not uncommon, but of course it should be reflected in your offer. Those are great negotiation leverage points, and strengthen your value add options. Priced right, there's massive upside. So I treat deferred maintenance as a reason to investigate further and chase the deal, as long as the seller is reasonable.

Dorothy Butala · Answer

What are your 5 and 10 year goals for the property/properties you are investing in?  I am curious why you use cap rate in your metrics...

Also, you may be able to put money into a C class property, but deferred maintenance isn't the only factor in making a property a C Class property...desirability of location and lower rent rates should be taken into account, and regardless of how much money you put into a property, sometimes it can only hit a ceiling in terms of rent that can be realized as well as the class level it can achieve.

How do you treat "deferred maintenance"?

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