I recently had the privilege to attend a multifamily syndication conference filled with value-add operators. Throughout my discussions with them, one of the most common stories I heard from folks regarding their recent deals is that they have been experiencing tremendous rent growth over the last 12 months without doing any renovation or improvement work. Now, for these operators and their investors, that’s great news; they have achieved the desired rent bumps they underwrote in their pro formas without having deployed additional capital into the deal. Some of these operators have started to consider whether it’s now worth even going through with the business plan, as technically the returns have already been achieved.
This is not the first time I’ve heard this kind of story recently; one of my partners invested last year as a limited partner into a syndication in the southern US, and the general partner a year later is selling the building at almost double the purchase price with barely any capex spending. These are very similar stories to those purchases of the early 2010s, when investors were buying up apartment buildings pennies on the dollars and just riding out the economic cycle to their profits. If you’re a general or a limited partner on this kind of deal, of course you’re most likely smiling all the way to the bank. Yet, from a macro perspective, and for those looking to continue to acquire assets, this should raise a little bit of a red flag.
We have to remember that at the end of the day, we are investing intro brick, mortar, and other tangible materials. If these do not get properly updated over time, these materials over time will of course begin to erode and worsen. At some point, someone will need to update items such as the electrical, plumbing, roof, siding, and other major components of properties. If many of these buildings in a hot multifamily market (such as the one we’ve been experiencing for the last ~5-7 years) are getting traded without anyone actually investing into the buildings, at some point we may see someone end with the “hot potato” that can really have some bad consequences.
How can an investor, whether a general partner or limited partner, avoid this kind of trap? First and foremost I believe you should at all costs avoid the mindset that if an investor you know recently executed on this strategy, you can just replicate the same. If there are any shifts in the market that all of a sudden make it easier to unload a building (i.e if our increasing interest rate environment will actually start to decompress cap rates) and you’re not properly prepared financially and operationally to execute on these renovations, you can be in trouble.
Second, this also implies that having quality operations is absolutely crucial; if your investment group does need to execute on any real remodeling, it’s imperative they can do so feasibly. Lastly, it’s cliché, but you must stay grounded with your underwriting. Avoid having strong rent growth projections just because the last year or two a market has blown up, and maybe do consider the fact that interest rates can impact your exit cap rate values in a few years.
