What a Real Deal Looks Like - Don't Be Fooled!

Question

So the name of the thread - loaded subject, and maybe as this thread unfolds we will touch on a lot of things, but to kick this off:

@Sam Grooms and I just had a meeting with our PM at the  98-unit we closed on August 17th . Present for the meeting were Sam, myself, the regional, and the on-site manager.

I see people doing a lot of deals most of which I wouldn't touch with a 10-foot pole. I see things being called value-add that I would call a pig, first thing in the morning before it has a chance to put lipstick on.

So, just to underscore what a deal looks like, let me piss some people off.

While we were on-site for the meeting, several things happened:

1 - The on-site informed us that she is renewing 2x2 leases at $190 premium to in-place. This is without us touching the units. This is simply to re-capture the LTL.

2 - In one instance the increase was $290.

3 - A lady who is a current resident came into the office while we were there and proposed: If I find a place to stay for 3 weeks, can you get into my unit and remodel it? She was advised that her rent would go from about $850 to $1,150. Her response was - how soon can we do this?

Guys and girls - listen up!

1. It's much more expensive to own property than anyone wants to talk about.

2. Cash Flow depreciates much faster than anyone wants to talk about.

3. CapEx costs much more than anyone is willing to admit.

Value-add is the only saving grace there is. The IRR is the definitive metric, and it's very difficult to make things work (I'd say impossible), with anything less than at the absolute minimum $250 per door value-add. More likely $300.

All of those offers you are seeing with $150 of value-add per door are garbage...

Ike Ekeh · Answer

@Sam Grooms That's awesome! I bought a small deal in North Phoenix in May earlier this year. I ended up having to evict a tenant who was taking very poor care of his unit. (I knew he would be gone as soon as I stepped into his unit @ inspection.) All in repairs including opportunity cost of lost rents while repairing was ~$10K. The rent will be going from $500 - $799. Which gives me ~36% annualized return.  The actual dollar return on mine will be nowhere close to the 31% on a 98-unit deal I would imagine, but still pretty happy about that one!

Todd Dexheimer · Answer

While I agree in principal. This is a very simplistic approach though. Saying a $150/unit bump for an apartment in the midwest that will rent for $700/month with a $3000/unit value add is not a good deal is short sighted. Also, take the $300/unit rent bump on a $2000/unit rent apartment that costs $20,000 to complete. In this case I would take the $150/unit rent bump.

You also have expenses that can be reduced and other sources of income as well that can make a successful value add. The other thing is the purchase price. If you purchase in in a market for a 7 cap vs a 6.5 cap that will make a huge difference.

Justin F. · Answer

Ben, I appreciate your sentiment on there being many 'value add' deals that are not truly value add details. There are definitely too many newbies on here solely assuming something is a value add because the broker told them so, but saying "$150/unit is garbage and $250-$300 is all that works" is too simplified an understanding, and perhaps a laughable statement depending on the context.

IRR is NOT the definitive metric on value adds.. you're not selling your renovation, so there is no terminal value, making IRR not even possible, unless you're comparing IRR under renovation vs non-renovation scenarios. Return on Cost is perhaps the most definitive metric used, but everything depends on the hold period and your goals. +1 to Ike for sharing that rule of thumb- but on larger complexes, 15-25% return on cost can certainly make sense. Time and effort is certainly a factor as well.

Could you explain what you mean by #2 "Cash flow depreciates faster than anyone wants to talk about" - I'm not sure what you mean.

TLDR; A real deal looks like: "A mom-and-pop manager who is clearly under-managing, not all value add opportunities are worth doing, so vet them thoroughly."

Sam Grooms · Answer

@Ike Ekeh, that's actually a good rule of thumb. Hard to find, but when you do, it'll definitely be worth it. We're sitting right at 31% on the deal Ben is mentioning above.

Justin F. · Answer

@Sam

There are many deals where a 15% ROC makes sense- think about longer term holds like a 10 year hold, or a 20 year hold. Or lower leverage investors looking for more stable cash flow making ‘defensive upgrades’ to compete with newer product. For investors with slightly different goals than you/Ben, the “$250-$300 is all that works” statement simply is too simplistic.

To start splitting hairs, ROC isn’t the only metric that matters- time and effort matters too- popping in a high tech Alexa enabled thermostat is a quick repair, but adding a backsplash takes a decent amount of time, even if the rental premium and cost were the same.

Furthermore, Return on Cost is hard to compare just like cap rate is, because it can be underwritten so differently from owner to owner, and occasionally incorrectly. If I am very conservative on my renovation estimate costs, that does not mean my 15% ROC project is not worth doing compared to the same project underwritten by someone who did not factor in labor, downtown, or the full renovation costs. E.g. my $7500/unit interior renovation may be the same scope as someone who penciled $5500/unit, and they simply forgot about the cost of adding a GFCI for a new microwave circuit, scraping the popcorn ceilings, and patching the walls.

@Ben Leybovich

Obviously investors should be contemplating an exit at some point, even if it is just a backup plan. It reminds me of those guys who customize their car so much that nobody else would want to buy it. Real estate is an asset you’re driving, but you should never forget about maximizing its resale value. The fact you said “most folks” do this scares me.

I get what you’re saying on inflation, and “Cash flow depreciates” was a completely incorrect way to express it, and likely confused most folks. A better way might be “inflation eats returns” or looking at your ‘real’ rate of return, and despite inflation, 8% Cash on Cash certainly will get you far if you’re patient.

Appreciation is NOT the thing that makes the investment, cash flow is the thing that makes the investment. Appreciation is just $150 / door can be more than enough, just not for your specific market rents, goals, and investment horizon. Just like the “1%” rule, real estate opportunities are too hard to compare across the varied markets in the USA and any hard and fast rules like that are hogwash. A better rule might be “Run the numbers, compare it to other similar deals, buy the best risk-adjusted ones.”

Ben Leybovich · Answer

Of course, it's a highly simplistic way to look at things. A better way would be this:

The money is made in the delta. If you buy at 5 Cap, but value-add toward an 8 Cap upon your basis, then if your exit is at 6 cap you are at a 2 Cap delta. You are making money. You will see the necessary IRR.

The question becomes - how much value add is necessary in order to achieve the sort of delta?

The answer is tricky. For one thing, the rental price-pint makes a huge difference. $300 of value-add on $2,300 in-place is a very different blended capitalization than $300 upon $550 in-place rents. Then there are expenses, etc.

For the most part expenses are what they are. There are many reports out there that track every line-item of OpEx. None of us are able to outperform the averages for very long. Planning on doing so is just not a sustainable model in my opinion. So, expenses are left out of this discussion.

This leaves us with the income. I am using the $300 per door number because most of us are buying units that are going to be in the range of $850 - $1,300 per door after renovation. In that range, in order to achieve the blended delta we are looking for we need roughly $300 per door of value-add.

Thanks for your comment. Something to make me think! I love it.

Ben Leybovich · Answer

Justin, good comments!

Te IRR requires the closure of the cash flow loop. As such, underwriting to the IRR requires some sort of an attempt at the pricing of the exit. Most folks perceive multifamily strictly on a cash flow basis, and the underwriting does not aim to describe why and how the exit will look like. The IRR requires us to do this, and this is important since this requires us to rationalize every step of the way.

Inflation this year is at least 3% or more. 8% COC doesn't get you very far. Appreciation is not the icing on the cake, but the thing that makes the investment. $150/door value-add is not enough.

Scott Morongell · Answer

Solid post. A lot of "value add" deals right now are not exactly what investors think they are.

Sam Grooms · Answer

@Justin Fishman, I think Ben was saying that the IRR is the definitive metric on the overall deal.

Also, I'd love to see a deal you've done or invested in where 15% return on cost on a value-add project in a hot market made the overall deal worth doing. That just doesn't pencil out for me.

What a Real Deal Looks Like - Don't Be Fooled!

Most Popular Reply