By Ryan Floyd
Across the Denver metro area, apartment rental rates and occupancy levels are hitting record highs which creates an attractive environment for landlords. By adding value to properties now, landlords have the opportunity to lock in the value of their asset for future stability. What are the best ways to add value in this market? Let’s take a look at three different methods on how investors can accomplish just this.
1. Stabilize Rent Roll
Effectively stabilizing rent rolls can be the easiest way to add value to your apartment asset however, it may also present the risk of capitalization rate compression. Some investors have been purchasing properties and simply flipping those properties six to twelve months later. Those decisions are based on the market going up in value and the capitalization rates decreasing. The strategy is to turn over a rent roll that may be 10% or more under market averages and to bring all of the rents to current market rates. By simply stabilizing the rent roll, value is added. Interest rates remain extremely low thus allowing cap rates to continue to drop. Cap rate compression can only happen as long as the delta between cap rate and interest rate is high enough for a yield.
This strategy works great in a market like Boulder where rents never seem to decrease and occupancy levels rarely dip. When vacancies increase, rent levels drop. When interest rates rise the scenario of relying on cap rate compression can quickly go from an easy way to increase value to an asset that could be potentially upside-down.
2. Perform Moderate Asset Rehab
In this method investors are purchasing properties and displacing all of the residents to rehab the entire building. Investors are drastically changing the curb appeal with new landscaping, painting, windows and replacing all of the appliances, cabinets, countertops, bathrooms, flooring, lighting, heating and cooling systems. These investments are sometimes upwards of $25,000-$35,000 per unit. Most of the time investors can obtain 75% of the loan for improvements including the building’s purchase price. Some loans allow for the debt service to be paid out of the construction loan, or defer payments upon completion. By doing this property owners avoid carrying a large mortgage payment during the vacancy time period. This process can take at least 4-6 months depending on construction schedules and the time it takes to vacate the building. Many investors choose this path as they feel like the finished product and the acquired tenant base are seemingly more desirable. The amount of capital from lending institutions that prefer this type of transaction are lending aggressively in favor of the investor.
This strategy is desirable if the investor has the resources and time to complete the renovations. In some cases we have seen this scenario achieve rent increases of 50-100% compared to the previous rents.
3. Renovate Vacant Units
A third approach to add value to an apartment property is to renovate as leases turn over. In this method investors are purchasing properties where some of the leases run month to month. In this scenario tenants are given a notice that their rent will be increased to the market rate. We have seen a surprising number of tenants agree to pay the rent increase as a result of the slim inventory of affordable alternatives. Alternatively, the units that are vacated are modestly upgraded with a slight increase of finish quality like: faux hardwood floors, new cabinet faces, new appliances, fresh paint and carpet, or new vanities and updated lighting fixtures.
Most investors who pursue this method try to achieve a 20%-30% rent increase as opposed to top of the market rental rates. They do this in order to prevent competing with new product or properties that have been completely renovated.
As a landlord, your profitability relies on tenant quality, however turning tenant quality over is a significant hurdle to overcome. A new tenant paying a higher rent expect quality amenities and cultural niceties more than the previous lower paying tenant. This type of renovation is typically a great strategy to achieve improved tenant quality however, the downside is that it could take 10 months to a year to achieve the anticipated value. This approach may not be as cost effective as the overall savings one would obtain with a full renovation, however the investor appeal is that the property has the ability to service debt and maintain cash flow while increasing the property value.
Aside from these three approaches, there are other ways to add value that investors may pursue like decreasing expenses or correcting management inefficiencies. However, if you are a new or seasoned investor who is planning for a change in the business cycle, the past tells us that in a market downturn, the properties that were well maintained were the properties that escaped the negative effects of the market.
We are a full-service firm specializing in the Denver commercial real estate market. With over 40 years of experience, we have the knowledge and skills to help our clients reach their goals. If you are looking for multifamily properties in Denver or have questions regarding the market, feel free to contact us today. We look forward to working with you!