Real Estate

Should You Shy Away From The ‘Best’ Class A Apartment Buildings?

When it comes to multifamily properties, some investors stick with Class A properties and see them as the best asset classes in the multifamily sector. After all, they are usually fully leased with top tenants, fetch market-leading rents, require little if any repairs or renovations and have a stable monthly income. Since investors pay a high premium for Class A properties, cash flow is not as high as in other asset classes. Hence, appreciation is the main factor that drives profits in many Class A properties.

Those investors see a value-add deal, mainly in Class B and C properties, as a risky investment. In a value-add deal, the new owner improves the property and renovates the units and the amenities to justify rent increases. Class A investors see that strategy as less favorable. After all, nobody can guarantee tenants will be willing to pay premium rents, even if it means that they get nicer apartments. Yes, there is an inherent risk in a value-add strategy deal, but there are several ways to mitigate that risk and own a property that generates higher yields than those seen in a Class A.

The Value-Add Approach

Value-add strategies can include simple cosmetic fixes like painting, landscaping and signage, or extensive structural renovations like upgrades to kitchens and baths, new carpeting, or a new gym or clubhouse. The more extensive the renovation, the more it will cost. In addition, there are repairs to consider, like new roofs, HVAC systems or plumbing upgrades.

For the most part, Class A buildings are not good candidates for value add, since they are already upgraded and charging top rents. On the other hand, Class B and C properties — apartment buildings that were built decades ago — offer the most potential for increasing income by improving those properties. Value-add strategy is well worth the effort. The reason for that is that new improvements equal higher rents, and higher rents equal higher net operating income (NOI), and this, in turn, has a major impact on appreciation. By doing so, you can basically “force appreciation” because you improve the property and positively impact its value (in addition to organic growth in the market).

Boosting The Net Operating Income

Compared to building a multifamily property from scratch, investing in an existing asset that has ongoing cash flow is a smart move. An A property generally has a high property tax, which will increase the front-end building costs significantly. On the other hand, making value-add improvements like minimal exterior and interior changes to a Class B are relatively inexpensive.

The modest returns of a Class A property with single-digit to low-teen internal rate of return (IRR) just isn’t enough when compared to the high-teen IRR results obtained when value-add is completed on Class B and C properties. After all, the goal of any multifamily investment is to increase the NOI, and this is accomplished by either increasing the property’s revenue or decreasing expenses. Improvements made to value-add properties will significantly boost the NOI. That’s because once the improvements are made, rent increases generally follow, and cash flow increases

Just how important is it to increase the NOI? Let’s say your property has 100 units, and this year you’re increasing rents by $40 per month. That amount represents an increase in revenue of $48,000 per year ($40 x 100 units x 12 months), as well as an increase in the NOI by $48,000. That is a substantial amount of money, and because of this additional revenue, the value of the property will increase as well. That’s why I’m a strong advocate of value-add deals, because I’ve seen rent increases thanks to property improvements.

Rent growth is currently positive and still possible with Class A properties, but the slowing market pace will translate to lower organic growth, resulting in even lower returns for Class A buildings. And if the economy shifts to slower growth, some tenants will vacate their expensive Class A apartments for much more affordable Class B properties, and I anticipate Class A properties to struggle with higher vacancy rates than they face today.

Understanding The Cap Rate

The overall rate of return on any property is based on income. Capitalization rates are market-specific and depend on the type of property class that’s involved. The cap rates are used to calculate the value of a property by dividing the net operating income by the cap rate.

Cap rate is calculated by dividing the NOI by the price paid for the property. As a general rule, Class B and C properties have cap rates between 5% and 7%, while Class A properties have cap rates between 2% and 4%. When cap rates decline, the property value increases. As the cap rate goes up, so does the risk on the investment.

If you can purchase a property and lower your cap rate using the value-add strategy, your profit can increase. As an example, let’s say your NOI is $50,000, and you purchased the property with a 10% cap rate. That equals a property value of $500,000 ($50,000 divided by 10% cap rate). If you can lower that cap rate to 8% by repairing and renovating the property, your property’s value would increase to $625,000. That is a solid 25% increase in value!

The Bottom Line

With a Class A investment, you are limited in how much the property appreciates; however, you have more control over the appreciation of a B/C property, and in fact, you can force the appreciation. There is still some opportunity to get a solid Class A deal, due to a mismanaged property that results in higher expenses to rents priced under market, but those deals are rare. Relying on market power to determine appreciation is risky. Since returns on the income of Class A are moderate, due to high expenses, the majority of the profit will come from appreciation. This limitation is not as severe in older properties, where a cosmetic fix can significantly improve NOI, along with the appreciation potential. This is one of the main reasons investors should focus on Class B/C properties.

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