Can Your Class C Property Become a B+?
- Mar 03, 2009
By Jeffrey Adler, The Sanctuary GroupSo you own (or are looking to purchase) a Class C property to turn it into a B+ property. Value-added investing in multifamily properties is the classic way of creating wealth and value for owners, investors and residents. Here’s how you do it.Location. The very first thing you should evaluate is the existing price point for other rental communities in the neighborhood. You should see a 15-25 percent rental rate increase potential for your target property. Value-added investing is about catching up to the neighborhood, not blazing a new trail. That’s what makes it a lower risk (and lower return 15-20 percent IRR) investment than new development (25-30 percent IRR). If you truly are revitalizing a neighborhood and will be leading the pack on rental rates, go seek out tax incentives from local government. Remember, they have a vested interest in a stable neighborhood, so if you’re going to take that kind of risk, be sure to be paid for it. In addition, ask yourself: what is unique and special about the neighborhood, and what type of person will be naturally attracted to the community? Is the school district very good? How safe is the area? Is the property near a new commuter rail line? Is it near a hospital, university, or major employment center? What is the access to shopping, restaurants and social activities? Is the neighborhood declining, stable or showing signs of improvement?The location of your property, and the existing reputation of the entire neighborhood (not the property, as it is usually the ugly duckling) defines the relevant customer segments you will be able to appeal to, and helps to define the exterior, interior, common amenity and customer experience design. It also is another powerful check on your rental increase assumption, upon which everything depends. Remember also that your “mental” target customer is always a woman, as women generally are more invested in their homes, will pay for safety and quality, and have a greater attention to detail. If you focus on serving women, you will also access the minority of men who share this great attention to detail, and are willing to pay for it. This finding is based on research, not stereotype, and was conducted for—and by—AIMCO during my tenure.Asset Quality. The next step is to have a very clear-headed assessment of the property’s physical condition. You can do a quick assessment yourself by doing an unannounced tour, and acting as a potential renter. Hire an unbiased engineering firm to give you a clear picture of what you’ve got. Not only should you get a plan for existing remedies, but you should require a 10-year capital maintenance plan going forward to help set your hold period budgets.Above all focus on the major building systems—HVAC, plumbing, electrical, sewer lines, elevators (if any), roofs, siding and concrete work. In general you will never be paid for these systems by renters—but you can deduct the cost of these repairs from the acquisition price. If you lose an acquisition because someone else will take on these costs without being paid for it, count yourself lucky, and look for another opportunity. You should see a useful life of at least ten years on any major building system that will not be renovated: long enough for your hold period and that of your future buyer.In general, garden apartments have more manageable capital investment profiles than high-rises, and should be the preferred path for most small- to middle-sized owners. Value-added investing in urban or suburban high-rises is a very high-risk game for very steep pockets. I have seen many of these have $50-$100M cost overruns—all due to unforeseen asbestos or plumbing issues.Resident Quality. This next issue is one often overlooked by value-added investors. Don’t you make the same mistake. You need to get a clear picture of the current resident base and how much of a change you will have to make in order to achieve your rental rate objectives. A good way is to use First Advantage/Safe Rent’s (www.fadv.com) PPA (property performance analysis) product. For about $6,000 they will tell you the credit quality profile of the existing customer base. It’s money well spent. The more financially stable the resident base, as defined by their credit score, the more likely that about 20 percent of the resident base can afford the new rents—which you can use to absorb the first one to two months of renovated unit production—and the less likely there will be incompatibility between new and existing residents during the transition.It’s not about how much money someone makes necessarily, but how responsible they are with the money they do have. Look closely during due diligence at the rent roll and how often partial payments are accepted, and what the collected security deposit was. Owners have a temptation to “stuff” a property before a sale—be sure you know what you’re buying. How compatible is your natural target market to the existing customer base? If reasonably compatible, you’re improving your odds; if very divergent, reduce your purchase price to compensate. A mistaken assumption here will cost you time, money, and a lot of effort. Get this right, and a lot of other things go right as well.Exteriors. When evaluating the current exterior, look at how far off it is from a more modern community. For a value-added redevelopment to succeed, it must give the appearance of reducing the age of the property about 15 years. This is where paint color, siding and roofing type, gabled entry ways, lighting, enclosed gates and landscaping all come into play. Pay particular attention to breezeways and stairways (or hallways in enclosed entryways/hi-rises). These must look crisp and have a high degree of attention to detail.I have seen many otherwise great projects fail because of a lack of attention to detail on breezeways/stairways/hallways. To achieve your full price point, the exteriors must be completed first, and you should be able to raise new and renewal rents on the power of the exterior renovation alone; however, if you’re concerned about how deep demand in the neighborhood really is, you can complete only a corner of a property and gauge consumer sentiment. You won’t hit your full price point, but you may obtain valuable feedback.Common Areas. Your common area improvements such as clubhouse, pool, kitchen, café, etc, must have a theme consistent with your targeted customer segment. Don’t just copy what the guy down the road has. If you must have common area laundry facilities (and I do mean must, these are generally rent killers!) make them special. There are a number of excellent Internet-based services for managing laundry times. Or turn the laundry experience into a café/wireless Internet area for young singles. Also, never skimp on the amount and quality of pool furniture and grills. They should look like a resort (no white plastic!) There are plenty of wonderful products available that are durable and look great at modest cost.Your common areas send a powerful signal about who you are and what the community is all about, and how your leasing staff will feel about themselves and the experience they will be selling. Think long and hard about whether to combine the existing resident office with the leasing office. This depends on how compatible the two customer bases will be. In general, while there has been a movement to split the offices, I think this in the end is a mistake. New renters are looking for clues as to how they will be treated. Focusing on the existing customer base, even when they are leaving, but being treated with respect is more authentic and will get the new resident relationship off on a positive footing. If your community is leveraging the school district, the common areas should reflect a family theme. This works even for people who don’t have kids. If you’re focused on professionals 25-35 years old, spotlight a common area kitchen and associated social events. Be careful about business centers. High-speed connectivity (and video) is a must for everyone now, so bus
iness centers generally subsidize at-home businesses to the detriment of the larger community, unless they provide unique professional benefits such as study groups for the bar exam, a medical library, or police, fire and teaching certification resources.Interiors. Here’s where most of the money is made (and where everybody loves to take pictures). The very first thing to determine is whether there are in-unit washer dryer hookups in the apartment homes. With hookups, you can turn the property into a Grade B+. Without it, you probably can’t—unless you’re in a high–end urban area where you can substitute a laundry service for washer/dryers and a small combination unit in the kitchen. I have done this successfully, but in a very limited way. From research we performed using a method called conjoint analysis (what hotels use to design new hotel concepts), we know that in-unit washer/dryers have a huge impact on price and demand. Installing water lines for in-unit washer/dryers can cost up to $12,000 per unit and may be justified if very little other exterior work is required.The rest of the suggested interior upgrades are rather well known, and they come in different product lines aligned with your target price point. Kitchen and bathroom cabinets, countertops, fixtures, appliances and lighting are available today in packages specifically tailored to value-added redevelopment. Check out National Cabinet Companyand Dogwood Building Supply for container-load prices.For flooring, avoid carpet in the main traffic areas, and limit it to bedrooms. Kardean, among other manufacturers, makes a great durable hardwood floor-looking plank laminate that wears well and looks great, as long as your sub floor is level. Pay particular attention to interior doors and door hardware (it should look modern) as well as the thermostat, bathroom fan, bathroom mirror and bath enclosure. Your objective is to remove any visible reminder of the age of the apartment. Also, focus on the use of interior wall color paint to create depth and dimension, and to create warmth. Your model should be consistent with the customer segment and should provide opportunities for the new resident to customize (paint color) or purchase (furniture) the look you have on display.How much can you afford to spend? Normally, you should expect to spend no more than $8,000-$12,000 per unit for all of your improvements to achieve a 15 percent rent increase, assuming you are buying the property at a market level cap rate. Of course, higher rental increases will increase your budget, and a higher average rent market (i.e. Washington D.C., Seattle, LA ) will also give you more room in your renovation budget.(Jeff Adler is president of The Sanctuary Group LLC based in Englewood, Colo. and is former Chief Property Operations Officer of AIMCO.)