If you are an active investor, you may be very familiar with the following three business models. If you seek to passively invest with a sponsor, your familiarity with the below models is of great importance. As you will see, each has its own set of unique pros and cons.
Turnkey
Turnkey investing is to acquire a stabilized asset, meaning an asset that is currently renting at optimum levels and in great condition. The obvious benefit to this strategy is that the property is livable, has renters and produces income on day one. Because of this predictable return on investment, relative to the other models, this is the least risky approach.The downside to turnkey investing is that the full value of the property is already achieved. As an investor, there is very little opportunity for adding value and forcing equity, which is a key wealth builder.There are sponsors and passive investors that focus on turnkey, and for those who want the stable return, similar to that of a mature, dividend-paying stock, they see turnkey investing as a fit for their needs and financial goals.
Distressed
On the other end of the spectrum is distressed investing. There are three forms of distress: Market Distress, Seller and Property Distress. What we are referring to here is Property distress. The property is the equivalent of the classic car parked under a tree in Georgia: lots of potential, but needs lots of work.Distressed properties provide the maximum opportunity for returns. However, the condition of the property is likely that which is not classified as livable, at least in many units. In multifamilies, a severely distressed property can have as low as 50% vacancy or even be totally uninhabited. Such condition and high vacancy presents an extreme risk to an investor and any partners involved.
The reason: There is no cash flow on day one. Without day 1 cash flow, especially in a Post-Covid environment, investors are betting on returns and rents from tenants that do not exist today. This is a harder hurdle to overcome, especially when the pressures of time and cash flow could be the soft pillow to rest on during these times of uncertainty. So how do you overcome this?
Value-Add
Value-add plays are the middle-ground of real estate investment strategies. It balances the opportunity to force equity through improvements and obtaining cash flow on day one. A value-add multifamily investment, may look like this:- 24-unit with 85% vacancy- 5 units need serious rehab- rents below market-insufficient rent collection system-owner self-manages Do you see the opportunity here? Value add allows multifamily investors to force the equity of the property by improving operations. You achieve this improvement by combinations of raising income and lowering expenses. By doing so, equity is created.
For example, if the above property cash flows positively today, but has upside in rent of $25 per door and further opportunities to reduce expenses by $100 per month, here is how the math plays out, assuming a 6.5% cap rate (refer to Real Estate Terms Resource Page).
- Annual Income: Increases by $7,200 ($25 rent increase x 24 units x 12 months)
- Annual Expenses: Decreases by $1,200 ($100 expense reduction x 12 months)
- Net Operating Income: Increases by $8,400 annually
- Property Value: Increases by $129,230 ($8,400 divided by 6.5% cap rate)
Voila, just like that, within a few years, over $100k in equity is created by simply raising rents to market value and reducing expenses by $100 dollars monthly. The numbers can get even larger with larger properties and different market conditions.Finally, these results are not unusual and is precisely why astute investors love multifamily as an asset class.
My Preference
Based on the above, when I seek investment properties, I am looking for value add opportunities. These present cash flow on day-one, which limits risks for investors, and value creation opportunities through operations, which creates wealth for all involved.
