How much value-add do you need?
I get this question a lot. Basically, it goes to the core of what is a good deal. Let’s shine some light on this briefly.
Some theory first
Let us underscore in simple terms why we need value-add to begin with. There are two profit centers when it comes to income property, and they are cash flow and appreciation. While this is true, most people fixate on the cash flow.
Here’s the issue:
Once you begin to hold buildings for extended periods of time and begin to figure out the cash flow dynamics, you start to see that CapEx over time cuts into the cash flow in a very big way. You make cash flow this year, and then the next year the furnace goes out, replacing which will destroy this year’s cash flow and last.
So, soon enough you begin feeling as though you are throwing good money after bad. About the only thing that inverts this circumstance is equity appreciation. While you may be giving up the cash flow to keep the thing running, if it increased in value then you feel OK, because you know that you can get this money back via equity on re-sale.
This is one reason we underwrite to the IRR, since it tracks all of the cash flows and therefore takes into account the proposed equity liquidation event on the re-sale.
In multifamily we control equity
So, the above established why we need equity. From here we simply acknowledge that in multifamily, we are able to control equity appreciation via value-add, and in order to be most in control of our fate we must only buy assets that allow value-add.
But how much value-add?
This is the exact conversation I had with a very sophisticated investor ad friend yesterday. I’ll tell you the same thing I told him.
The realities are very efficient, and while there are variances from deal to deal, for the most part, it looks something like this:
In order to achieve 17% asset-level IRR on a 10-year hold, which is required to achieve around 14% to the partners after the split to the general partner, we need about $300 per door of value-add, or slightly more. Given all of the rest of the numbers stay same, the five-year hold will look like about 17% IRR to partners, and a three-year hold at over 25%.
Now, I know what you’re thinking – how can I be so definitive with these numbers. After all, large multifamily and specifically syndication seem like such a black box to most people.
While these numbers vary with the purchase price and the amount of CapEx we are doing up-front, but multifamily is more efficient in a lot of ways than what it appears to a lot of you. After seeing these numbers for years we begin to recognize patterns.
Experienced players simply know what a good deal looks like 🙂
OK. I am off. Good luck on you value-add search!