Effective Profit Strategies For Multifamily Revival Capital Solutions

Effective Profit Strategies for Multifamily Investments by Asset Class

There are numerous approaches to earning profit in the commercial real estate space. Some investors choose to purchase and manage properties, while others act as passive investors at various levels in the capital stack. In addition to choosing what position to take in a deal, investors consider property types, such as residential or commercial, as well as into which property class or classes they want to invest.

Property classes range from A to D, and properties within a given class generally perform in the market similarly to others in the class.  In this article, we will examine the real estate classes for multifamily properties, the most profitable investment strategies for each class, and how you need to vary your financing strategy for each class.

Multifamily Real Estate Classes:

Class A

These are buildings in optimal locations and are perceived as high quality in their market due to a combination of factors such as amenities (high-speed internet, club room, home office, modern fitness center, swimming pool), professional management, and professional or high earning clientele in their market. Class A properties bring in the highest rents and maintain high residency rates. Properties are either developed from the ground up or acquired within 7-10 years of development.

Class B 

This may be aging or formerly class A property that is showing signs of wear. Landlords generally rent to middle-income or the lower end of high-income renters, and properties may or may not be professionally managed. Properties have been in use between 10 and 20 years, and the amenity mix may be aging as compared to class A properties.

Class C

A 20-year-old or older property that resides in a less-than-ideal location often falls into class C. These buildings often are in need of maintenance, repair, and upgrade, and the properties usually carry lower residency rates and bring in less rent per unit. In addition, many of these properties are four stories or fewer, and because of the age of the property, it may not be possible to upgrade amenities. Think of wireless internet that simply can’t reach through walls or through public spaces.

Class D 

These properties were either developed with section 8 and lower-income renters in mind or are class C properties that have fallen into disrepair. Most properties have been in the market for more than 40 years. The tenancy may see turnover due to earning capacity of the primary client, or payments may be late on a regular basis. Some units may be uninhabitable at the time of purchase, and the building itself may need an overhaul to bring it into alignment with higher incomes and residency rates.

Class-Based Investment Strategies

Many investors choose one or two asset classes in order to develop deep knowledge in a few areas and to mix risk profiles across property types.

Class A in Premium Markets

One investment strategy is to pursue premium buildings in premium markets such as New York, London, Berlin, Bangkok, Tokyo, Los Angeles, and similar cities. This is primarily conducted by corporations and financed through a number of means, including bonds, high-powered investment banks such as Fortress, hedge funds such as Baupost group, and sometimes bridge loans provided by more traditional banks and lending institutions. Individual investors seeking to enter this market do so best through shares in a property or bonds, depending upon the structure of the deal.

The risk in this category is that the investment group is unable to bridge the gap between concept, development, and, ultimately, profitability, especially when the project is built from the ground up. Markets may change in the time it takes to secure funding and necessary permits to get the project off the ground.

While income is more stable, class A projects may provide a lower annual return on investment to owners due to cost-of-capital and mortgage payments during the initial phase of the operation. At the same time, these properties, once developed, are seen as lower risk in the overall real estate market because of generally high demand.

Class A in 2nd or 3rd Tier Cities

Because property classes are based on a relationship to their market, a class A property in Salt Lake city may have fewer amenities and a significantly lower cost of development than a class A property in New York or Los Angeles. Because of the lower cost of development and smaller scale. Class A properties are in range for many medium-sized local or regional real estate businesses. These properties are funded by a more traditional capital stack.

Class B

The greatest opportunity in Class B, whether the properties are in primary or secondary markets, is to restyle and add amenities that result in premium rents within the class. Bringing amenities and design up to class A levels, improving the professionalism of management, and often rebranding the building to appeal to a different demographic can significantly improve profitability.

For a time, styling properties to be “selfie ready” from all angles was de rigor. During the pandemic, a home office with a great backdrop, or ready for a digital backdrop was a dealmaker. Anticipating the market and working with an innovative interior designer goes a long way to creating an investment win.

The important factor for investors to evaluate is whether money can fund aesthetic upgrades, which increase the cost of rent, or if they need to be sunk into mechanical systems such as HVAC, plumbing, electrical, and internet or other communications systems, which are mandatory, but do not command rental premiums.

Class C

In this arena, because property values are depreciated, return on investment can match or sometimes exceed higher classes. However, there are a lot of variables that impact the return on investment. The neighborhood and proximity to transit, jobs, and shopping matter significantly, such that the success of another venture, such as an urban core redevelopment, can make or break the class C investment opportunity.

In general, modest upgrades within the property class make it more attractive than others with similar features resulting in slightly higher rents and/or higher occupancy rates, resulting in more consistent cash flow in its class. High occupancy rates can result in consistent and sometimes higher margin returns due to lower cost of upgrades. A consistent maintenance and repair plan is important, however, to maintain the reputation of the property in the eyes of its renters and to prevent the property from falling into class D.

What do the risks in class C look like? Incorrect forecasting around a location or property is one of the greatest risks. When the numbers are off it can lead to imbalanced reinvestment in the property. Economic downturns can put earnings at risk, because many renters are in working-class jobs that ebb and flow with the market. Proactively managing these properties is a must.

Class D

With the right plan, class D properties can see significant upside. These properties are essentially non-functioning, whether that is due to crime in the area or neglect of repairs and maintenance in the property making some are all units uninhabitable due to safety and code violations.

Most class D properties were Class C, and in some instances, Class B properties that fell into disrepair. To see upside in these properties, the investor needs to be able to negotiate the right purchase price and to have the financial stamina to take on a bridge loan to redevelop, rebrand and fill the property with renters, then refinance the building into a permanent loan.

To make the redevelopment effort work, companies need to have a clear target in the class C or class B range, and proforma estimates on redevelopment need to be accurate. Sometimes quirky projects with sound bones, such as the redevelopment of a brick schoolhouse or industrial building into apartments, condos, restaurants and shops can follow a similar format to apartment redevelopment. In the class D sector the goal is to create an attractive destination with a lot of aesthetic appeal that creates delight and surprise as compared to the property’s history.

Matching lenders to your property investment strategy

The lender that has an appetite for class D properties is different from lenders who are attracted to class A financing.  Lenders comfortable making a $2 billion loan on a new tower in Manhattan are quite different than those willing to lend $20 million on a downtown apartment building in Cedar Rapids, Iowa. These cases are also far from the lender ready to support a bridge loan to fund the overhaul class D property in any of those markets. That’s why partnering with an experienced loan broker is so important.

Loan brokers who regularly work on multifamily property deals can help you match more quickly with the right lender, getting your deal done faster so you can get out of the planning phase and into operations and revenue-generating activities. In addition, they can do more than source loans. They can help you structure an actionable capital stack and bring in investors at each level of the deal.

Here are some initial strategies investors and mid-sized commercial real estate investors can consider.

Class A in Premium Markets

When pursuing premium buildings in premium markets, investors often leverage complex capital stacks.  These may include bonds, investment banks, and multiple investors.  The primary risk in this category is that the investment group is unable to bridge the gap between concept, development, and ultimately, profitability.

Class A and B Investment Strategy

An “A + B” strategy allows investment firms to balance risk. “A” properties are long-term investments, as loans consume the major portion of cash flow during the first decade of operations. B properties have been in operation, and with a range of cosmetic and amenity upgrades, they can bring in higher margins than the standard A property.

The higher revenue from a number of upgraded B properties offset the risk of a higher investment A property. At the same time, the addition of A properties to a B property mix mitigates risk in the long term, as A properties will age into B properties. The increased cost of maintenance and repair of an existing B property portfolio, or the loss of revenue should B properties fall into the C category, earning lower revenue and serving a higher risk renter, can be offset by the long-term returns of A properties.

Investors in the A + B strategy need to have clear benchmarks on when to sell off or redevelop B properties or purchase/construct new A properties to maintain their overall mix.

The lenders our team secures for clients in the A + B category will likely be traditional big banks, private lenders, and preferred equity-focused private equity firms. Ultimately, an A + B strategy allows our clients to pool assets when seeking financing for new construction or acquisition.

Class B

Class B properties are clearly focused on opportunities afforded by amenity upgrades in the short run, backed by bridge financing, and appreciation in the long term.  A class B business model will often be financed on bridge or agency debt, and redevelopers need to know if they will plan to rent and hold (refinance) or redevelop and sell (often called “fix-and-flip.”)  The exit strategy is a key factor we use when selecting the right lender for each client.

Class B and C Investment Strategy

A strategy combining B and C properties shares some attributes with an A and B strategy, but the overall focus will be on increasing margin through targeted smart maintenance and upgrades to maintain the attractiveness of a property among renters. B tenants have lower turnover than in a C property, but with a range of properties in each class, a business can make targeted decisions for each property to maximize overall return.

The pool of properties also provides opportunities for combining assets to collateralize loans, reducing interest rates due to the lowered risk carried by lenders.  Depending on the scenario, we often help these clients to secure portfolio loans.  At other times, when individual properties are financed, we will leverage lenders who base their underwriting on After Repair Value (ARV), a projection of value based on comparable properties by location and property class.

Class C Investment Strategy

To gain the most from a class C property that is intended to be managed as a class C property, accurately anticipating the target rental audience and proactively managing rental rates is important. Because rent is lower in in these properties, taking on too much debt can increase their risk profile and eat into profits.

In the case that owners target a class upgrade, we typically focus on loans can be secured on ARV. In this case, the forecast on the neighborhood, shopping, access to job centers, transit, as well as on site amenities have a significant impact on profitability. Development in a C strategy is generally through ARV financing or pooling multiple class C properties with our portfolio loans.

Class C and D Strategy

Any time class D properties are in the mix the focus is on redevelopment to achieve a better rating and a property that can be rented and managed. With a class C and D strategy, the goal is to use Class C to provide revenue sufficient to stabilize the business while the class D property is off the market.

Class D investment requires financial stamina. The property can rarely be upgraded one unit at a time, as can be done in many class B and C management strategies as tenants turn over. That means the property must be purchased, current operations closed out, and a robust redevelopment completed.

When helping clients in this space, we are often leveraging our network of private lenders.  In addition, we may work to help clients bring in the right investors to round out the financing strategy.

Class D Strategy

An exclusively class D strategy is most often built around a redevelopment or “fix and flip” approach. In this case, a bridge loan is issued, and the redevelopment firm courts buyers from the concept stage all the way through completion. If buyers are unwilling to purchase until they see proof of concept, the developer has to hold the property long enough to rent it up, at which time, the potential buyer pool increases dramatically.

Building the Capital Stack

At each level of the industry, the capital stack will look unique. Class A properties often have much more complex financing processes than B, and C. D properties rarely have preferred equity and mezzanine financing because the cash flows and risk profile generally aren’t a fit for that investment type.

No matter what property class you specialize in, our team is ready to help you source the financing necessary to get your deal done. From innovative investment products to strategizing your capital stack and sourcing funds, the team at Revival Capital Solutions is ready to serve you.

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