The four reasons to budget CapEx for Multifamily
Multifamily real estate investing is a business. You deploy capital into properties, and you reap income.
But not every apartment property is producing as much income as it could be.
For this reason, real estate investors budget capital expenditure (“CapEx”) dollars to improve the property, in the hopes of increased income.
You must spend money to make money — Plautus, 184 BC
I’m not really sure who Plautus is and if he’s the first person to utter the famous “spend money to make money” moniker, but it needs some qualification. It’s really not a surefire thing to spend money to make money in multifamily. Just spending dollars on a property doesn’t guarantee that you’ll be paid back in time via increased operating income. For instance, you can spend money on a new amenity that isn’t valuable to your tenant base, or redesign an apartment in a way that isn’t any more attractive than the old design.
Good investors know that spending money wisely helps make money. Knowing what types of upgrades you can deploy into a given property in order to increase the income and, therefore, the value of the property, is how you win on this real life monopoly board. The best CapEx projects have the highest Return on Investment (“ROI”) because they produce more income on less dollars invested.
You can think of a construction project as one large CapEx project. Building a building where one did not yet exist, and successfully producing income from it at a favorable return, is the ultimate CapEx project. At that point, you’ve earned more than the title of multifamily real estate investor… you’re now a real estate developer.
But you don’t need to become a full-blown real estate developer to understand CapEx. When you own a property that’s already built, there are four plausible reasons to budget capital expenditures:
- Raise occupancy
- Raise rents
- Increase tenant retention
- Change property use
CapEx to Increase Occupancy
Vacancy is the very first killer of income that you’ll find on a property’s income statement. When you see vacancy on a property, your next question should be: Why?
After all, someone built that space with the idea that a tenant would pay to occupy it.
While there are many potential reasons for vacancy in a property, several of them hint that CapEx may be required to solve it. Those reasons include:
- Old property — if a property was built a long time ago, it might be time for renovation or rehab in order to attract new tenants.
- Deferred maintenance — a property falling into disrepair is one of the most common reasons for CapEx in order to catch up with necessary repairs.
- Weak amenity offerings — the types of amenities offered for a property’s tenants really varies based on asset type, class, and location. Studying available amenities for competing properties helps determine if something new should be built or offered.
CapEx to Raise Rents
So you have tenants. Nice. Next question: Are they paying market rents?
Increasing the rent at a property is likely the most common reason a multifamily landlord deploys a capital plan for their property.
But be warned! Raising rents too rapidly can result in a trade-off of lower occupancy. The lower occupancy will be temporary if you are now appealing to a different set of tenants (higher income). The lower occupancy can be permanent (or until you drop rents back down) if there is no demand for your units at the higher rent level! Studying comparable properties and their vacancy rates to your new price point can help determine if there is demand for your units at the new rent level.
CapEx to Retain Tenants
Let’s be honest, maybe you found a nugget or two above, but increasing occupancy and raising rents were the two reasons that already came to mind in conjunction with CapEx.
Sometimes, CapEx is necessary just to keep the tenants you have. If you have an older property that needs some TLC, or some competing properties are offering tenants better value, pulling out the checkbook to give your property a boost may be in order just to keep the status quo on income.
But did you know that tenant retention is also one of the most powerful ways to improve your property’s income?
An example: You own a 10-unit apartment complex. On average, 3 units turn over each year. You always rent up the vacant units, but it takes 4 weeks on average for a new tenant to move in. That means there are 12 total weeks vacant each year across all 10 units.
What if you could prevent just one of those 3 tenants from leaving your property?
Every tenant “saved” in this scenario boosts the property’s value by roughly $23,000. Is listening to your tenants needs and making some small upgrades to the property worth this gain in retention for your property? It might be worth the peace of mind as well!
CapEx to reposition the asset
A major rehab or repositioning project is usually going to be a large Capital Expenditure in comparison to the property’s current value. Here it’s important to really underwrite the full cost of the repositioning or renovation to determine if your cost numbers are accurate, especially in this day and age of surging lumber prices.
That said, the right repositioning of a multifamily property can pay major dividends to investors. While no two repositionings are the same, here are some common elements:
- Executing a large scale renovation to update an older property.
- Changing the physical appearance of the property substantially.
- Adding a number of unit upgrades and amenities at the same time.
- Potentially changing the name of an apartment complex to a new brand.
As with the warning above in the section on raising rents, this strategy is absolutely one that changes the tenant base you’re appealing to. Beyond appealing to new tenants, this type of CapEx project may also help appeal to a different class of buyers that are interested in investing in the asset where you’ve improved the quality.
The play here is trying to maximize the value of the asset not only by increasing the net operating income, but by improving the multiple at which the building is valued.
Not mutually exclusive
When enacting a Capital Expenditure plan on a multifamily property, the reality is you are not simply picking one of the above outcomes to the exclusion of others. The same repair or upgrade to a multifamily property may very well lead to higher rents and higher occupancy. A repositioned asset may achieve higher rents, lower vacancy, and higher retention. You can and should model various scenarios for how a CapEx plan will affect the income and value of your property at completion.
None of us have a crystal ball. All of us have a brain. Use your instincts to think creatively about how you can best position your multifamily asset in its given market, model it out, and make the decision that will lead to the highest projected return.
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