Want an investment that generates 20 percent annualized return without taking on any risk at all? Well, sorry to break the bad news… no investments are risk-free.
However, there are certain things that you can do when investing in real estate to minimize your risk exposure. This article will go over the benefits and risks of an apartment value-add.
What Is an Apartment Value-Add?
An apartment value-add is defined as buying and renovating an older apartment to increase its rents and eventually sell it at a premium. This investment strategy typically takes three to five years.
Benefits of an Apartment Value-Add
An apartment value-add has many benefits, such as stable cash flow, protection against inflation, forced and natural appreciation, and tax benefits.
Stable Cash Flow – Since the property is already in operation, its existing cash flow will help you sustain the building through a market downturn. This gives you the choice to hold on to the property and sell it after the market recovers. The last thing you want to do is sell your property at a highly discounted price while the market is down.
Protection Against Inflation – Apartment rents typically increase at least 2 percent every year to account for inflation. This rental growth will ultimately increase the building’s selling price.
Forced and Natural Appreciation – Adding value to an apartment through renovations is called forced appreciation. Natural appreciation, on the other hand, depends on the market’s employment and population growth. Investing in a fast-growing market will accelerate the rate of natural appreciation, allowing you to increase rents more quickly. Keep in mind that some underwriters don’t account for natural appreciation in their underwriting. In this case, the property should theoretically perform better than what’s projected.
Tax Benefits – There are many tax benefits, such as depreciation, lower tax rate, tax deductions, interest deductions, capital expenditure, and 1031 exchange. You can also invest in an apartment using a self-directed IRA, which makes all your capital gains completely tax-free if it’s a Roth-IRA.
Risks of an Apartment Value-Add
Investing in a market with a diversified labor force minimizes your risk exposure to the decline of industries. For example, Venezuela is a petrostate, where oil sales accounts for 98 percent of its export earnings and 50 percent of its GDP. When the cost per barrel of oil dropped from $100 to $30 in 2016, Venezuela’s economy was hit hard, and its inflation rate consequently rose to more than 1,000,000 percent.
This is an extreme example, but it shows the importance of avoiding markets that are heavily reliant on just one or a few industries. Examples of such industries are military, construction, college or education, and technology.
DataUSA and Bureau of Labor Statistics are good references for getting information on labor diversities. To check if an industry is significant, compare the percentage of local jobs in that industry to the percentage of U.S. jobs in the same industry. If the percentage of local jobs is higher, then that industry is significant.
The interest rate, which is affected by the Federal Reserve’s policies, is another important risk variable for multifamily investments. Since the bank typically finances about 70 to 75 percent of an apartment’s value, a higher interest rate will greatly reduce the return of your investments. A higher interest rate will also slow down the economy in general, which will ultimately affect your property’s rental growth.
You can’t control what the Fed does, but you can tie down permanent financing for your property early on to lock in the interest rate. You also want to lock in permanent financing as soon as you can so that you’re not forced to pay back the loan prematurely while your building is struggling.
If you are investing in a deal brought to you by a syndicator, then you should do some due diligence by verifying the syndicator’s assumptions, such as market rents, expenses, and vacancy rates. Market rents can be verified by checking comparable properties—make sure that the unit counts, amenities, and unit sizes are all comparable. Expenses are typically 40 to 50 percent of the property’s effective gross income (EGI). General vacancy rates can be found on DataUSA.
Again, having stable cash flow is great for minimizing risk exposure, so look for properties that can cash flow within the first few months of your acquisition. If your property is not cash flowing and you can’t meet your debt services to the bank, then you will be forced to sell your property. To avoid defaulting on a loan, make sure that you have enough capital reserves and your underwriting is conservative.