There’s a lot more than meets the eye when comes to renovations of apartments. Simply making an apartment look “nice” would be something an outsider of the industry would think. If you’re going to be deploying capital into a building, you need to think strategically about the grade of the renovation in context of the location of the asset, the class of the building, the market cycle, and ultimately your exit strategy. Trying to squeeze dollars for the sake of squeezing dollars is a one-dimensional view about a process that is key in generating returns in the investment.
The first two considerations, location of the asset and class of the building, are more straightforward for people to digest. A building that is a Class A building should in theory have nicer finishes than lower grade buildings as the rents in this building are going to be higher. The same concept with location is true as well; a building in a better or more desirable location is naturally going to command higher rents and attract wealthier tenants, necessitating higher finishes. Nothing earth-shattering here so far.
Now, with regards to exit strategy, this analysis can become more complex. Most active multifamily investors understand the concept that higher rents in their buildings will result in higher valuations of the assets on an income-valuation basis. Now the question first becomes if you’re thinking about selling the building down the line, how do you maximize your return on the invested capital? You’ll need to figure out at what point do extra finishes/renovations stop generating a meaningful increase to your NOI and ultimately your sales value.
For easy math, let’s look at an example of a kitchen renovation. On many of my units in the early years, I used to try and keep costs pretty low and use cheaper granite countertops, low-grade cabinets, cheaper hardware, and skimp if possible on appliances such as dishwashers (that’s just asking for more headaches I would tell myself). As I’ve become more experienced and started to play in higher quality locations, I began to look at the math and think about scenario of increasing my budget by say ~25-40% (call it $3K per kitchen renovation). You could look at that line item and deduce that my idea of now having quartz countertops, higher grade cabinets with better hardware, and a more high-end appliance package would not necessarily be “rental efficient”. Yet, if by investing this extra money I can just get an extra ~$300 per month in rent (and that’s actually a low number), I’m increasing my NOI y $3600 per year, which capitalized at a 5-cap market would entail an additional of $72,000 in value. That’s pretty darn good ROI.
This exercise actually becomes even more interesting if your strategy is to perform a cash-out refinance. Let’s say you have raised equity for your acquisition and your goal is to return that capital through a cash-out refinance as quickly as possible to maximize your investors’ IRR. Well, if you want to cash-out as much cash as possible, you’re of course going to want to maximize your value at refinance. Does investing some additional capital into the renovations to increase the BOI of the building make sense if you can get more cash out at your refinance and return more capital quicker to your investors? Not only that, but every additional dollar earned on your NOI gives you more room on your DSCR calculations, which allows you to increase the LTV on your refinance.
Though the above financial calculations are important, there is one more final factor that I think may be most important of all. The markets right now have taken a big turn, and there is a lot of talk of economic slowdown and a potential recession. Apartments are not fully immune to these economic changes, and as operators we need to put ourselves in the best possible position to remain competitive. If you’re squeezing dollars on your renovations and not putting out the best possible product you can on the market, you’re jeopardizing your building. Having a downgraded product will hurt your topline revenue, increase your vacancy, and can ultimately put quite a lot of pressure quickly on you. Make sure you’re putting yourself and your units in the most competitive positions you can, even if it means spending a little more money.
