For apartment owners trying to manage in a recession, the textbook approach is to cut costs, retain tenants, refinance debt and dump under-prforming assets if necessary. In the current recession, widespread job loss means that vacancy in some submarkets is threatening to destabilize operating performance for some owners. The reaction has been to hoard cash and line up small capital loans to make it through.
The smart operators are also looking ahead and planning or executing strategic renovation. What's crucial to understand is how those operators define a 'renovation. ' It is not a capital expenditure to reduce operating costs, although such investments might be prudent if the reduction pays for the investment within two years. Ideally, the owner has already put such economies in place during the fat years when refinancing cash was readily available.
Likewise, renovation is not the replacement of building systems, structural components or new construction which preserves asset value, extends the useful life of the physical plant, increases ad valorem tax cost and disrupts the residents-- these steps will be deferred until borrowing is readily available to finance the work, a new owner steps in, or a casualty occurs for which substantial insuirance proceeds can be used for the purpose.
The renovation which owners have in mind is what will garner an immediate increase in monthly rent. In recent years, the median renovation for Washoe County was less than $ 5,000 per unit, bringing in a median rent increase of $ 85 per month and had a pack-back averaging 4.5 years. Assuming that 85% of the rent increase showed up in the bottom line, net operating income increased 9% on average, with building value climbing $11,000 per unit at an imputed 8 cap. Return on renovation investment approximated 45 % if the asset were sold and had a payback of 4.7 years.
Admittedly, some owners who want to renovate are skeptical they can increase rents anytime soon and have work planned but want to feel the bottom of the soft rental market first. Others lack the cash, and still others are hoarding cash against the worst case of operating performance. But three of the five conditions for the timng of optimal renovations are here: (i) units are readily available for renovation; (ii) labor is patient, flexible and hungry; and (iii) material costs are flat or falling, with trade vendors willing to deal. Seldom have renovations been cheaper or faster to install than now. And tenants, who have choices, are value-conscious.
The smart operator is working through the following process:
- What's my serious competition and how do my units stack up ?
- What work should I do to avoid functional obsolescence ?
- Realistically, what amenities or improvements does the location justify ?
- What improvements are most prized by the tenants I really want to retain ?
- What can be done to continuously improve the curb appeal of my units ?
One highly sophisticated apartment owner we work with uses a clever technique to lock in the benefit of a renovation. Systematically, he asks the best residents, "We're going to raise rent for your unit by $100, and we want to know what improvements you would like us to consider that would make the extra rent worthwhile." And then , he follows through. It's the best mix of resident relations and value-add you could imagine.
As a broker, when I raise the issue of renovations with owners, I like to ask if the owner would spend $ 225,000 to acquire units worth $ 500,0000. Not one would turn down that opportunity. A skillful renovation delivers that level of return, without transaction cost, legal expense, financing risk or substantial delay..