René Nelson with Pacwest Commercial Real Estate asks the expert, Zoe York, MAI Appraiser with Duncan and Brown, about value-add opportunities for multifamily properties in Eugene-Springfield. Learn about the options to consider before you try to sell your multifamily property to maximize your sales price.
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René Nelson: Let’s use the example of a 1970s 20-unit apartment complex in the Eugene-Springfield market. You and I have talked in the past about how sometimes owners are slow to raise rents because they’ve had tenants there for a long period of time, but now they’re behind the curve for where market rents should be. One thing I talk to my clients about is before you get ready to sell that, maybe what you want to do is go in and remodel some of the interior units, let’s take 12 months, increase rents, and then put it on the market. Talk to me about that value-add opportunity and how do you weigh that as an appraiser?
Strategy for Rent and Utilities as a Value-Add Opportunity for Real Estate in Eugene
Zoe York: I love that you say that you counsel your clients on doing that, because that’s so important. I see a lot that property owners, particularly estates or properties where they actually really do need to get rid of the property quickly or they have pressure from family members, where they go and list the property in as-is condition, as-is state of income, and they don’t spend a lot of time either before the sale or even years before considering selling it, making sure that they’re maximizing their income potential. Unfortunately, what that means from an appraisal perspective or from a value perspective is that you’re losing a lot of your potential property value just upfront. When you have a property that has below-market rents, sometimes deferred maintenance, or maybe it needs unit updates, particularly in a market where rents are increasing and there’s a lot of demand, and you just sell it as-is, somebody else is taking on that risk.
Zoe York: Even in a market where there’s a lot of demand, there’s still risk. There’s risk of construction costs, there’s risk of timing, there’s risk of rent loss. There’s just overall risk, and somebody else is assuming that risk. When somebody else assumes that, they are going to want to discount the property significantly. So not only are they discounting the property for the current state, but also the property is being valued on income that could be higher, maybe on rents that are below market because of long-term tenants, and this can sometimes cause 20 to 30 percent value difference on a property.
Zoe York: When I say a 20 to 30 percent value difference, I don’t even necessarily mean that you would need to put money into it to get that 30 percent extra value. What I mean is that you could spend some time raising rents and making sure that you’re on par with market, and then sell the property and without putting another dime into it except your time and efforts to make sure that you’re maximizing your income. You might achieve a 30 percent higher sale price just from doing that. That’s a really, really important thing to understand for anybody who not only is looking to sell their property soon, but also if you don’t anticipate holding your property for a long period of time, you should start thinking about those things now. Even if you do anticipate holding your property for a long time, it should be in everybody’s best interest to maximize your income.
Zoe York: There’s a lot of ways to do that, particularly in a market with rising rents, and the first is to raise your rents. A challenge that people are running into right now is that particularly owner-managed properties, they might be $200 or $300 below market rent, and it doesn’t mean that you can’t raise it $200 or $300 on all of your tenants, I’ve definitely seen that happen, but a lot of people have sort of moral problems with doing that. So what that means is that if you want to raise your rents $50 every year, you have a pretty long catch-up period. If you don’t want to raise your rents by a massive amount all at once, then you want to start working on it today. You don’t want to wait any longer, so you would want to have a property manager that you talk to about strategizing some sort of rent increases, but that’s definitely one place to start with your value add.
Zoe York: Another thing that we’ve talked about quite a bit and that I’ve seen is instituting a utility bill back. Utilities are not a fixed expense. They go up each year, and you can kind of temper your exposure to increasing expenses by passing that on to the tenants. A lot of times, it can’t be a dollar-for-dollar expense pass through, but you could charge a flat fee, $25, $35 per month to your tenants, and a lot of times that doesn’t translate to a mental rent increase for your tenants because it’s market-wide. It’s something that if you rented a house, you would have to pay those utilities. If you rented a duplex, you would have to pay those utilities. Pretty much market-wide on the larger professionally managed complexes, you can expect a base rent plus a utility bill back, so it’s a way to raise your rents without raising your rents. That’s another value-add opportunity.
Investing Capital as a Value-Add Opportunity for Real Estate in Eugene
Zoe York: The third value-add opportunity is investing some additional capital into your property, and what that would look like would depend on what your property looks like—its condition. Sometimes you have deferred maintenance and you have to invest capital just to bring the property up to market standards. That’s also a necessity because if you went to sell the property and it had substantial deferred maintenance, the buyer is going to expect to pay you what it’s going to cost to cure that plus a profit to account for their time management risk. In any circumstance where there’s deferred maintenance, you’re better off curing it before you sell or before you go to market it if you know about it. Also, a better opportunity is just not let it get deferred to begin with. Make sure you’re staying up on maintenance on a regular basis so your units don’t need substantial improvements to just stay on par with market. That’s one way to add value, but really that’s more bringing your property back up to where it should be.
Zoe York: The other opportunity is to basically rehab units upon turnover or as you can to make your property more appealing. I see a lot of that happening with 1970s properties. Usually property owners will rehab upon turnover. They won’t go through and vacate all their units and rehab them all at once. It just happens upon turnover, so this ends up being a two-, three-, or four-year process sometimes depending on how big your complex is. But because the wider market area is doing that, it’s something that if you have a project with dated finishes that you haven’t gone through and done unit rehabs in the last 10 years, then it’s something you should really consider if you want to maximize your rent opportunity because you can’t continue to increase your rents year after year if you’re comparing to other units in the market that have had rehabs.
Zoe York: The last thing I want to talk about in terms of unit rehab is how much unit rehab is enough. I don’t really specialize in feasibility analysis of cost benefit in terms of cost and do a rehab and resulting rent, but I do see a lot of units. I inspect a lot of units. I look at a lot of rents. I look at a lot of market activity in our multifamily complexes, and the units that I go through that are in the best condition, that seem to get the highest rents and don’t seem to have a lot of value loss in terms of return of their improvements are kind of doing the bare minimum to make the unit look fresh.
Zoe York: In a 1970s unit, you’re not putting granite countertops. You wouldn’t update the cabinets to the highest quality cabinetry in a 1970s unit because you’re not going to get the return on your rent increases. Why? Because you’re going to be comparing to other units that have just new flooring, new laminate countertops, some new paint, and some new fixtures, and that’s going to look the same and rent the same to a tenant as your granite countertops. You might get more wow factor and get tenants in that they are really excited and it has more appeal, but that doesn’t always translate to rent.
Rene Nelson: Yes. Don’t you see sometimes that investors put it in because they have pride of ownership and they think, oh, I really want this because maybe they have it in their own personal residence and they think, well, my tenants would like this, but then when the tenant comes in, they’re not willing to pay for that extra granite or the tile or whatever has been added in?
Zoe York: I do see that a lot, and most of the time it’s the owner giving me the tour and they say, well, I want to make this unit something I would want to live in. That’s a great moral practice, and I think in general in terms of cleanliness and overall feel of the complex, safety, I think that is important. Make sure that your tenants are living someplace that you would be okay living, but I also think that there is a threshold.
Zoe York: There is a threshold for return on your investment, on your capital, and cost does not equal value. It very rarely equals value in a lot of circumstances in appraisal, and so you want to be very careful about how much money you’re putting into a property. You don’t want to put too much into it depending on how old it is and the overall feel of the complex is. If you’re going to do a full rehab of your entire complex and make a 1970s complex look like a 1990s or 2000s or a brand new complex, go ahead and do that. But if you’re going to keep your property looking like a 1970s complex, you don’t want to go through and put too much over improvement into the units.
For more information about investing in commercial real estate in Eugene, call me today: René Nelson, CCIM, (541) 912-6583 / rene@1031guru.com / www.eugene-commercial.com
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