Education, Strategy

Using Renovation to Improve Cap Rates and Property Value

By Matt Picheny

Adding value to both the asset and the community at large helps increase the value of your asset. This can have a dramatic and positive impact on your bottom line, and it makes you, as an investor, an asset to your corner of the world.

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* This article was first published in Rent Magazine

My book, Backstage Guide To Real Estate, chronicles my adventures going from an actor to a full-time real estate investor and shares the 18 keystone concepts that I learned along the way. Keystone Concept #4 is all about adding value. 

With this strategy, you purchase an asset that is not at its best and highest use and then improve it. Maybe it’s a property that was built 30 to 40 years ago and hasn’t been updated since.  Often, value could be added by doing upgrades to unit interiors by putting in new appliance packages, new paint, or new flooring.

You can also make improvements to common areas like hallways and lobbies. Perhaps you can add some amenities to the property like a dog park or new pool furniture. These types of improvements really add up in terms of increased value while substantially improving the quality of life for the folks who live there.  These are the type of win-win deals that I love.

Why A Value-Add Strategy Works

Commercial real estate is valued through a simple mathematical formula. All investors use this to evaluate a property. This is the standard in the industry and is the way it is taught by everyone from articles like this one to podcasts, to mentoring groups, and even classes at prestigious universities.

Here is the formula:

Cap Rate is a metric used to evaluate different properties under the same terms so as to be able to make an “apples to apples” comparison. It removes the financing component and assume that a property is purchased on an all-cash basis. This way, investors understand a property’s performance regardless of financing.

What Is Forced Appreciation

I like to invest in deals where I can make improvements to the property that I know will increase the value right away, rather than hoping that forces beyond my control turn out to be good for me. I invest in deals where I can affect changes at the property and increase the NOI myself.  If the NOI is increased, then the value of the property is forced up—hence the term “forced appreciation.”

A Value-Add Strategy In Action

This doesn’t only work on large apartment complexes. Here is a real-world example of how this worked on a 6-unit property that I purchased. During our due diligence phase, the residents were given a few days’ notice that inspections of the units were going to take place. Overall, they were in good condition, except for one particular unit. 

Entering this unit with the inspection team was sort of a blur to me. There were a lot of people there. I remember there was someone passed out on the couch—this was at mid-day during the week. The unit itself was a shambles, filthy and disgusting. The unit had a washer and dryer and the dryer had been ruined.

These residents had been in the unit for a few years. Their rent was below market and below the rent of the other two-bedroom unit in the building, even though this unit was a little larger and could be nicer than the others.

I knew that whenever these residents moved out, we could do a nice renovation on the unit and achieve much higher rent. I would never kick them out, but I thought that within a few years they might move out on their own.

As fate would have it, the day after I closed on the property, they stopped paying rent. My property management team spoke with them about this several times over the course of a few months.

We asked if they were having a hardship or if we could work out a payment plan, but never got a response and, unfortunately, had to bring them to court. They were evicted from the property. This was unfortunate. It was not something we wanted to do and was certainly our last course of action.

After they moved out, we had a crew come in and clean the unit. I went to the property and talked with a contractor and pointed out some places where we could make some modifications to walls and door openings to make the place more open. I had them renovate the entire unit. New kitchen, new floors, paint.

The renovations were not cheap. The unit was a disaster and we had to replace the hardwood floors. We even removed portions of walls.

Finishing Thoughts

Adding value to your property can be a wise investment.  It improves the quality of life for the existing residents, giving them a nicer place to live.  This can reduce vacancy and turnover costs.  In addition, owners can see a significant increase is their monthly cash flow and a meteoric rise in the property’s valuation as a result.  Implementing a value-add strategy can be a win-win for everyone involved.

The information provided on this website is not advice and does not purport to be a substitute for professional adviceYou should seek out the services of professionals who are experts in the fields of investment, legal, and accounting concerning your specific situation. The author disclaims any responsibility or any liability, loss, or risk, personal or otherwise, which is incurred as a consequence, directly or indirectly, of the use and application of any contents of this website.