Dollar for Dollar: Balancing Value-Add Budgets
Investors should expect to pay one dollar in improvements for every dollar spent to acquire the asset, says Ryan Perk of Pangea Properties.
Which will bring a greater return on investment: money spent to acquire a property or money spent to refurbish it? While the answer depends on a number of variables, the two budgets should work in tandem.
A relatively new, turnkey property will likely need few repairs, whereas bringing a heavily distressed building back online could require a hefty capital expenditure. And then there is the investor’s exit strategy. Do they have a fix-and-flip business model, or do they plan to operate the asset over a period of many years?
For value-add properties, investors should consider a dollar-for-dollar approach. That is, expect to pay one dollar in capital expenditure for every dollar spent to acquire the property—if not more.
Consider 6904 S. Creiger Ave. in Chicago’s South Shore neighborhood, for example. Pangea Properties purchased the building as part of a portfolio from the Better Housing Foundation (BHF) in July 2020 for $390,000. At the time of acquisition, the property had numerous code violations that required extensive repairs.
In order to create a safe, comfortable, quality living environment and enhance its investment, Pangea undertook a rehabilitation campaign that addressed the boarded-up ground-floor windows, broken downspouts, unsafe stairs, missing lighting and numerous other improvements. Those repairs were budgeted at $624,254, more than 1.6 times the acquisition price.
It’s important to remember that the recommended dollar-for-dollar budgeting in these cases is the floor, not the ceiling. This may be too high of a price for an investor seeking a quick exit. But for real estate investment companies that hold onto properties for the long term, that expenditure is not disproportionate since it brings vacant units back online and increases future rent revenue.
Investors who acquire, refurbish and operate formerly distressed assets may also want to consider the benefits of certain higher-cost finishes. Installing vinyl plank flooring instead of cheap carpet, for example, or heat-resistant granite countertops rather than laminate will drive up the capex budget. However, if this helps the marketing team to find and retain residents, the added costs are well worth it. Additionally, more durable and modern finishes will require fewer repairs and replacements down the line, resulting in lower overall operating costs.
When it comes to value-add properties, the acquisition and capex teams need to be in constant communication from day one. If an acquisition manager goes to tour a potential asset, whoever holds the construction budget purse strings should be right there as well.
The due diligence for a value-add property can be very extensive and a construction manager will have the expertise to know if a porch meets the city code standards, if a boiler requires upgrading and whether a roof needs minor repairs or if it’s a tear-off. More importantly, they will know the costs associated with these repairs for the market and can assess if the ROI will pencil out.
An investor can partner with a trusted third-party contractor to help them make these decisions. However, it’s far easier (and, ultimately, more cost conscious) if they have an in-house construction management team. Even if an outside contractor were to give a fair assessment, their goals are not aligned with the investor, and they may downplay potential cost overruns.
As the multifamily market is so hot right now, there is a lot of capital in the marketplace making aggressive bids on apartment buildings. Now more than ever, it’s important to know when to buy and when to walk away from a deal. Value-add acquisition teams simply cannot make an informed decision without consulting their construction managers.
Ryan Perk has been with Pangea Properties since 2014 and currently serves as acquisitions manager. He attended Indiana University where he received a double major from the Kelley School of Business. Ryan loves all things real estate, the broader financial market and good bourbon. His favorite activities include exploring all of the great neighborhoods of Chicago and discovering all of the fantastic food options out there.