Steppingstone #2 - Value Add Apartments
Updated: Nov 3, 2022
Once an investor has rolled their investment dollars through two, three, or maybe even four rounds of steppingstone number one type properties, they have usually reached a point where they have a $500,000 to $1,000,000 (or maybe even more) down payment that they can use to purchase what for the past decade, has been the “Holy Grail” of real estate investing—value add multifamily. Value-add multifamily is a little different, in my mind, from the “fixers” in steppingstone one. This second steppingstone property may not look so bad from the street. It may have zero vacancy. It might have been a fabulous cash cow for the prior owner for the last 20 years. What you can’t see from the street, is that the owner has not replaced the water heaters or furnaces in 20 years. Maybe there is some old shower surrounds that are falling apart. The counter tops are Formica (or ceramic tile) and cabinets are melamine. Everything is still functioning, but the units are tired. Because the prior owner has neglected the updates through the years in order to scrimp or squeeze every dollar out of the property they can, the rents are below market by maybe $200 or possibly even $500 a month. The tenant profile is less than desirable. There are probably some shady characters living there. All of these factors are reflected in the overall value of the property. If comparable properties are selling for $200,000 per unit, this one might be worth $120,000 per unit as-is.
In rides our real estate investor on her white stallion with an offer to purchase the property, let’s say it is 20 units for $2,400,000. She puts $800,000 down and gets a loan for $1,600,000. She keeps the rest of her $1,000,000 from steppingstone one in order to begin the updates. The property still cashflows with the debt, so some of the update and repairs they make can be paid for out of the properties own cashflows. The rest will be paid for by the investor from the $200,000 she had left. That is $10,000 per unit, which usually is about what it takes to update a kitchen, appliances, fixtures, paint, flooring, and do some exterior updates to clean everything up. As units are updated, those units will rent for higher than the ”classic” (unrenovated units), but they probably will not be getting the max “market rent” until the majority of the units have been updated and the tenant profile has been raised due to the increased rents across the property. Those increased rents help supercharge the renovations.
Once the renovations are substantially complete, many investors will complete a cash-out refinance. We would expect the value of the property to have increased because now you have $400 per month more rent coming in on all units which equates to $96,000 more in rental income per year. Using a 5.5% cap rate, that increase in rent would have increased the value of the property by over $1.5 million! So if she purchased the property for $2,400,000, it is now worth over $3,900,000. If you did one renovated unit a month, you could force a million and a half dollars in appreciation on this type of property in less than 2 years. Now, that wasn’t free to do--you probably spent $200,000 to $250,000 on the renovation, but even then, you created $750,000 of wealth per year! A lender might loan you 60-75% of the appraised value, which means you might get a loan for around $2,550,000 which is about $1 million more than your original loan after you pay it down for two years. This will pay you back the $800,000 you put in as a down payment and the $200,000 you put into the updates. Now, you effectively have $0 in this investment. You are likely cash flowing $40,000+/- a year after debt service, you still have $1,500,000 in equity remaining in the property to be accessed at a later date by selling or another refinance AND you can now take the $1 million and do it again. If you do this one or two more times, you can move to stepping stone number three.
I have one client currently who we have helped do three properties that would fall into this steppingstone in the past 5 years. They are now selling all three and hoping to roll their accumulated equity from all three into one single property that falls under steppingstone number three. It is exciting to see their years of sweat, blood, and tears paying off!
Below is a spreadsheet showing how some of the details outlined above might look for the investor.
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