The COVID-19 pandemic has created a catastrophe around the world, including the United States. In addition to the staggering loss of life, the economy has taken a major blow that hasn’t been seen since the recession during World War II. And just as the economy began to recover, a major spike in new cases occurred that has sent many states reeling, and reversing their attempt at restarting the economy
The resulting unemployment and unprecedented job losses have many multifamily property owners concerned, and rightly so. After all, it’s hard for people without income to pay monthly rent, which could have a devastating impact on the property’s cash flow. So far, Blue Lake Capital, my company, has been fortunate because we’ve been able to weather the storm. In fact, we’ve been able to generate a rent increase of almost 30% during this time. In this article I will share with you how we did it, step by step.
Implementing a Value-Add Strategy
Implementing a value-add strategy requires either increasing rents or reducing expenses. With value-add, rent increases are based on renovating units and charging tenants a higher rent. The scope of renovation can change depending on trends, but a popular strategy is to change out older appliances with black or conventional stainless-steel ones, install plank flooring, painting the units, and adding new kitchen and bathroom cabinet doors. It also includes installing a new backsplash, new hardware, and new lighting. Generally, the costs can run from $2K to $7K.
After the renovation, we can usually increase rents by 15% to 20%. The difference between the existing rent and the new rent that incorporates the increase is called the “premium.” As an example, if we were charging $1,000 per month pre-renovation, and we achieved a 20% premium, the new rent would be $1,200. That’s an increase of $2,400 per year per unit in income that goes directly to the bottom line.
It’s all based on the market, taking into consideration what people are paying in the market, and availability of units. You can also increase the value of the property with upgraded landscaping, painting, and other exterior renovations, but the main driver of a rent increase is renovating the units. In addition, when we renovate units we’re not only increasing our income, we’re also increasing the value of the property, and when we go to sell we can usually sell it at a much higher price.
When purchasing a multifamily property, we start the value-add process by renovating all vacant units first, and each time a tenant leaves (when their lease ends), we renovate the unit and rent it with the higher rent. That was the process used pre-COVID-19. After COVID-19 hit, things changed.
Post-COVID-19 Value-Add Strategy
Prior to COVID-19, we implemented our value-add strategy and started renovating all the vacant units almost immediately, and then put the units back on the market. When COVID-19 hit, most sponsors put renovations on hold. There were three reasons for doing that.
First, considering that we we’re worried about rent collections from existing tenants, it didn’t make sense to pursue increased rents. We wanted to focus on collecting rents from existing tenants, and also make sure that tenants stay, instead of encouraging them to leave so we can renovate their units and put them back on the market at a higher price. Whenever a lease was ending, we told tenants we were going to renew their leases for a zero percent increase.
The second reason was that we assumed it would be much easier to find a tenant who was willing to pay $1,000 per month, for example, than one who was willing to pay $1,200 per month.
The third reason for pausing renovations was to maintain capital. Maintaining capital is important in general, but it is critical for sponsors who don’t have a lot of funds in reserve. The logic is simple: sponsors prefer to have money to pay bills and a mortgage then to spend funds on renovating units. Having reserves was critically important as the U.S. saw a decline in rent collections. While it wasn’t a huge decline, going from 95% to 92%, sponsors wanted to have capital in reserve in case the decline got worse.
We Took a Different Approach: Renovation on Demand
In the early stages of COVID-19, everyone thought tenants wouldn’t want to pay additional rent for upgraded units. However, we decided to take a different approach. Instead of making the decision for the tenant, we decided to give the tenant a choice. Whenever a prospective tenant inquired about an apartment, we gave them 2 choices: either rent a non-renovated unit for, say $1,000 a month, or pay $200 more, and sometimes $250 more, and get an updated, fully renovated unit. We showed them a non-renovated unit and a renovated unit (which was our model unit) and let them choose. We called it “Renovation on Demand”.
We knew value-add was an excellent opportunity to increase rents and we didn’t want to abandon that opportunity, even during COVID, but we had to be sure that the renovated units were not sitting on the market and not being rented right away. By letting the tenants decide, we changed our model to a “Renovation on Demand” one. We had our model unit renovated so the tenant could make his or her choice, as they could view both the renovated and non-renovated units.
Much to our surprise, we found that starting April 1st 70% of new tenants chose to go with a renovated unit. We realized that not everyone had lost their job or were impacted financially. From March through June, we were able to raise our rents from 10% to 29%! Renovation takes between 7 and 10 days, and we only began the process after a contract was signed — and that was a key factor in our plan. We only spent the money after a new tenant signed the lease.
Taking a different approach really paid off for us. By thinking outside the box and creating the “renovation on demand” model, we were able to generate substantial additional income as new tenants signed leases.
Choosing the Right Market
One thing to remember, however, is that your property needs to be in a market that is strong enough to absorb the rent increase. You have to buy properties in the right market and the right neighborhood, as well as purchase the right type of asset if you want to do value-add. Tenants in a strong market are more willing to pay for a better and nicer apartment. Otherwise, you may find that only a very small percentage of tenants would opt for the renovated units at an additional cost.
We focus on Class A and B areas and look for Class B properties. They are usually properties that were built in the 1970’s, 80’s and 90’s. These properties look good, don’t have a lot of deferred maintenance, and tend to attract the right kind of tenant base who are willing to pay a premium for a nicer apartment — in our case up to 29% more in rents.
Not Much to Lose
Taking the “renovation on demand” approach is a viable option for many sponsors. After all, you don’t have much to lose by showing tenants a renovated unit and a classic unit and letting each tenant make the decision on how much rent they’re willing to pay. If you’re a passive investor, you can reach out to your sponsor and discuss this approach, because there really is minimal risk.
Remember, you’re not investing any money until a new contract is signed by the new tenant, and because there is generally a lag time between the time a new tenant signs a lease and their move in date, it’s the perfect opportunity to renovate the unit prior to the actual move.
The COVID-19 pandemic has changed a lot in the multifamily property arena, but if you’re in a strong market and you are using a value-add approach, you may find as we did that not only will rent collections not be adversely affected, but also that tenants are more than willing to pay a premium to have an apartment that meets their unique standards.
There are many challenges to getting rent increases during a pandemic, but with some hard work and an innovative value-add strategy it’s quite possible. Pre-COVID-19, sponsors were able to increase rents as new tenants come on board by renovating the units. Don’t assume that due to COVID-19 people won’t want to pay a premium for an upgraded unit. We developed a “renovate on demand” strategy that gave our tenants a choice between renting an upgraded unit at a premium or a “classic unit,” and almost 70% opted for the renovated one at a higher rent. Analyze the data to be sure you’re in a strong market, because tenants in a strong market are more willing to pay for a nicer apartment. Finally, remember that by renovating units you’re not only increasing your monthly income, you’re also increasing the value of the property when it comes time to sell.
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About the Author
Ellie is the founder of Blue Lake Capital, a real estate company specialized in multifamily investing throughout the United States. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don’t have access to.
Ellie is the host of REady2Scale , a podcast that focuses on the “APS” of real estate: Asset, Process, and Strategy. Each episode discusses how investors can scale their real estate portfolio and/or businesses.
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.