Want an investment that generates 20% annualized return without taking on any risk at all?
Well, sorry to break the bad news... because no investments are risk-free; however, there are certain things that you can do when investing in real estate to minimize your risk exposure.
This article will go over the benefits and risks of investing in an apartment value-add.
Apartment value-add is buying and renovating an older apartment to increase its rents and eventually sell it at a premium. If you’d like to learn fundamentally more about what it is and how it works, check out my other blog post “Secrets To Building Passive Income For Early Retirement”!
Apartment Value-Add – Pros
An apartment value-add has many benefits, such as positive cash flow, protection against inflation, forced and natural appreciation, leverage, and tax benefits.
Positive Cash Flow – A property with positive cash flow has enough net operating income (NOI) to pay for the debt services. Since apartment value-add is renovating a building that is already in operation, its existing cash flow will help sustaining itself through a market downturn. On the other hand, a development project or house flipping has a negative cash flow while it's under construction, so the project might be put on hold or sold at a discount when the market declines
Protection Against Inflation – Apartment rents typically increase at least 2% every year to account for inflation, and this rental growth will ultimately increase the building’s selling price as well.
Forced and Natural Appreciation – Adding value to an apartment through renovations is called forced appreciation. Natural appreciation, on the other hand, depends on the market’s employment and population growth. Investing in a fast-growing market will accelerate the rate of natural appreciation, allowing you to charge higher rents more quickly. Keep in mind that most underwriters don’t account for natural appreciation in their underwriting, so properties should theoretically perform better than the projected return.
Leverage - Banks typically finance least 70% of the project value, which allows a real estate investor to scale up his or her portfolio and make higher returns; however, as amount of loan increases, the deal becomes more risky.
Tax Benefits – There are many tax benefits, such as depreciation, lower tax rate, tax deductions, interest deductions, capital expenditure, and 1031-exchange. You can also invest in an apartment using a self-directed IRA, which makes all your capital gains completely tax-free if it’s a Roth-IRA.
Apartment Value-Add – Risks
Investing in a market with a diversified labor force minimizes your risk exposure to the decline of industries. For example, Venezuela is a petrostate where oil sales accounts for 98% of its export earnings and 50% of its GDP. When the cost per barrel of oil dropped from $100 to $30 in 2016, Venezuela’s economy was hit hard, and its inflation rate rose to more than 1,000,000%.
This is an extreme example, but it shows the importance of avoiding markets that are heavily skewed toward one particular industry, which can be military, construction, college or education, technology, etc.
DataUSA and Bureau of Labor Statistics are good references for getting information on labor diversities.
The interest rate, which is heavily dependent on Fed policies, is another important risk variable for multifamily investments. Since the bank typically finances about 70% to 75% of an apartment’s value, a higher interest rate will greatly reduce the return of your investments. A higher interest rate will also slow down the economy in general, which will ultimately affect your property’s rental growth. You can’t control what the Fed does, but you can tie down permanent financing for your property as early as you can to lock in the low interest rate.
If you're investing in a deal brought to you by a syndicator, then you should do some due diligence by verifying the syndicator’s assumptions, such as market rents, expenses, and vacancy rates. Market rents can be verified by checking comparable properties – make sure that the unit counts, amenities, and unit sizes are all comparable. Expenses are typically 40% to 50% of the property’s effective gross income (EGI). General vacancy rates can be found on DataUSA.
Again, having a stable cash flow is great for minimizing risk exposure, so look for properties that can cash flow within the first few months of your acquisition. If your property is not cash flowing and you can’t meet your debt services to the bank, then you will be forced to sell your property. Make sure that you have enough capital reserves and your underwriting is conservative, so this doesn’t happen.
I hope you found this article helpful, and feel free to contact me directly if you have any questions.