By George Roberts III
Repositioning is the process of renovating an existing multifamily asset so that the owner can increase rents thereby “forcing appreciation” to increase the value of the building. This value can be tapped into through a sale or a refinance. In a reposition, you may renovate a class “C” asset so as to make it a class “B” asset (or possibly C- to C+). This usually involves not only replacing fixtures and flooring, but also improving the exterior of the building and landscaping as well.
How much does it cost to reposition an apartment?
First, you need to answer the question of why rents are below market? Do you have an absentee landlord who has failed to keep up with market rent increases, didn’t market the property actively and let repairs slide for a couple of years? Perhaps all that is needed is to raise rents to current market level, add a website for greater marketing exposure and a fresh coat of paint while catching up on the maintenance backlog. If a property has been neglected for a longer period of time, you may have extensive mechanical and structural updates that need to be performed along with updating the fixtures and flooring. In other cases, a property may be suffering greatly by being “dated”. Would the units look a lot better by simply painting over the current avocado-green color scheme? Then maybe a light reposition is the way to go. It is key to assess which improvements tenants are willing to pay for in your local area. Look closely at the amenities offered by nearby apartments and how much these amenities allow the owners to charge in rent.
A “light reposition” may cost $2,000 to $5,000 per unit and may cover flooring, new countertops and a fresh coat of paint. A “medium reposition” may add cabinets and significant exterior improvements may run $5,000 to $10,000. A heavy reposition may require a complete tear out to bare studs and replacement of mechanicals and may be between $10,000 and $20,000 per unit. Costs will vary greatly depending on/ what is considered standard in your area and local labor costs. You can influence the costs greatly by your ability to bargain with suppliers and contractors. Time is money, and your ability to stay on top of contractors and properly sequence the job can greatly impact the overall cost of the project and its rate of return.
Remember, the exterior is the first thing that tenants will see. If they don’t like the building, the sign and the landscaping, they aren’t going to make it to the rental office to request to see a unit from the inside. Apart from a fresh coat of paint, the most impactful updates you can make are to the exterior of the building and the landscaping – think in terms of curbside appeal. As far as interior updates go, you will usually get the most bang for the buck by focusing on the kitchen, followed by the bathrooms. These are the rooms that provide the biggest lift in terms of rent.
Exercise – Test Your Knowledge!
Congratulations, you have purchased a 27 unit apartment for $2,000,000 with conventional financing at 80% LTV. Your closing costs total $50,000. Your current average rent per unit is $615. After completing a survey of rent comps, you believe that the property could charge around $750 per unit if some outdated fixtures and finishes were updated. The renovations will cost $15,000 per unit which includes extensive improvements to the exterior of the building and landscaping. What would your cash on cash (CoC) return be after the repositioning? For simplicity, we will assume that the renovations were completed lightning-fast (one year) and that the rents collected for the year are $192,000 (remember, in actuality you will lose a lot of rent during repositioning). Also, note that the cash flow from disposition (or refinancing) will be much greater than the cash flow from operations. Your remaining balance on the mortgage after one year will be $1,562,000. What is your CoC return?
Purchase Price: $ 2 Million
Closing Costs: $ 50,000
Operating Expenses: $ 80,000
Monthly Mortgage Payment: $ 8500
Annual Operating Expenses: 80,000
Rent collected in year 1: $192,000
Market Cap Rate: 6%
Remaining balance on mortgage after one year = $1,562,000 (you can arrive at this figure using an online mortgage calculator)
NOI for year 1 = $192,000 – $80,000 = $112,000.
Cash flow from operations = NOI – debt service = $112,000 – $102,000 = $10,000
Cost of renovations = $15,000 * 27 = $405,000
Cash invested = $450,000 + $405,000 = $855,000
NOI after repositioning = $750 * 27 * 12 – $80,000 = $163,000
Cash flow after repositioning = $163,000 – $102,000 = $61,000 – a nice “bump”
Value of the asset after repositioning = $179,200 / 0.06 = $2,716,667
Proceeds from sale = Sale price – mortgage balance = $ 2,716,667- $1,562,000 = $1,154,667
Total Return = proceeds from sale + operating cash flow – cash invested= $1,154,667+ $10,000 – $855,000 = $309,667
CoC return for year 1 = Cash flows in year 1 / cash invested = $309,667 / $855,000 = 36.2%
A return on investment (ROI) of 28% may or may not be a great rate of return depending on how long it takes to generate that return. For simplicity, we assumed that the apartment was completely repositioned and then sold in exactly one year making the CoC return equal to the ROI. If it took you two years to make the sale, you would need to annualize the ROI by taking the nth root of (1 + ROI) where n is the number of time in years. Suppose that it takes you two years to get a 36% ROI, you would take the square root of (1 + 0.36) to arrive at a CoC return of 16.6%. If it took three years, your CoC return would fall to 10.8% which you would calculate by taking the cube root of (1 + 0.36).
If you calculate the discount rate at which the net present value of all cash flows is equal to zero, you will arrive at the internal rate of return (IRR) a very useful metric that allows you to compare investments that have very different timing of cash flows. ROI takes into account the timing of cash flows whereas simpler metrics such as CoC and ROI do not.
Despite the large cash on cash returns possible with a reposition, many investors prefer stabilized assets rather than repositioning class C assets to class B assets. The volatility in returns inherent in a reposition make this a riskier, though potentially highly-rewarding approach. In the example above, if you overestimated rents and were only able to charge $700 rent per unit, you would end up having to hold onto that investment for cash flow rather than being able to dispose of it immediately. Your second year gross scheduled rents would be $226,800 which with $80,000 OPEX and $102,000 financing would leave you with a mere 4.6% CoC return for holding the asset even before considering vacancy. No investment is without risks!
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This article has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for legal, tax, or accounting advice. You should consult your own legal, tax and accounting professionals.
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