1. Account for adequate vacancy and downtime during renovation period
A rolling renovation of multifamily units creates a sustained period of vacancy in the property.
It’s important to consider the loan’s coverage requirements. Some lenders will consider a property in technical default if coverage falls below a certain level. Technical default requires a grueling review process with the lender until coverage covenants are met.
Budget adequate time to both renovate and lease the newly renovated units. Keep in mind that a large vacancy can take months to lease-up, especially if the goal is to lease them at above market rents. Leasing at higher rates is easier in the summer months when renters move more frequently.
2. Reserve for debt service coverage in renovation period
A healthy operating reserve is a must during a renovation or redevelopment of a dated multifamily property.
Budget overruns are commonplace. A kitchen renovation can easily turn into a plumbing and electrical overhaul. A 5% reserve is common on new construction, but a 10% reserve is better suited for renovations as there are more unknowns. Keep your reputation in-tact, don’t go back to the bank or investors and ask for more money.
Plan to release unused reserve funds at the end of the renovation period.
3. After renovation rent assumptions
Some investors believe that a renovation will always create rental upside, even if a property is leased at market levels. This is a dangerous assumption. Not all redevelopment projects will create a market-high rent rate.
While an aesthetically pleasing renovation might not create large rent increases, an investor might see less time between tenants, higher retention, and less repairs and maintenance.
Be conservative when estimating after renovation rents. It is rare that a property is currently leased “under market” given its current condition. After renovation rents should be budgeted to bring a property’s rents to market, not above.
4. Bad comparable properties
Comparable property selection is crucial to estimate after renovation rents. Some investors fail to apply the common-sense test to their rent comparables. A property built in the 1960s will never achieve the same rents as a property built in 2010. Not all “B+” assets are created equal, and vintage should be considered.
Neighborhood is THE MOST important factor when considering comparable properties.
Two properties separated by a river, railroad, or major road are most likely not good comparables. Pick properties within walking distance to each other. If good comparable properties aren’t available for your purchase and renovation, use extra conservative assumptions to make sure after renovation rents aren’t above a reasonable market assumption.
5. Account for interest rate moves at refinance, and their impact on valuation
The end of a value-add renovation can be a nightmare for an investor. If borrowing rates have increased since purchase, an investor might not be able to refinance as effectively as anticipated.
Even worse, a rise in interest rates might drive up capitalization rates, leading to a reduced property value. In some cases, value-add multifamily investors will have to bring money to the table in order to refinance their property.
When planning a value-add renovation, run a sensitivity analysis on your model to make sure you’ll be able to weather an increase in borrowing rates upon completion.