Picture a beautiful Class A apartment with amenities.
It’s got a hot tub, a sauna, state-of-the-art fitness center, and meditation rooms.
The temptation to invest in these brand new apartments is real.
I never do for one simple reason:
It is the highest risk deal within real estate.
A lot of people will disagree with me.
I have a lot of friends who do Class A apartments.
I’m not trying to offend anybody.
I just have a different approach.
Instead of Class A, I focus on value-add deals.
Today, I’m going to explain why in three simple steps.
Let’s jump into it!
1. The High Risk of a Class A Deal
Let’s talk about Class A deals.
Class A typically means the building was built within the last five to ten years.
So what happens in a recession?
I live in Pasadena, California.
They have listings for apartments like this where it’s $4,215 per month for a two bedroom.
In a recession, people tend to move from Class A to Class B.
Class B is typically a 10 to 20 year old property.
If the property is 20 to 30 years old it’s usually a Class C.
There are also some really rough properties that are considered Class D.
The reason a lot of groups move into Class A is REITs, or real estate investment trusts.
Large syndicators, such as Grant Cardone, will invest because they have too much money.
You might be thinking: What do you mean they have too much money?
When you raise $500 million, you can’t go into a B or C property.
You can’t do value-add to increase the value of rents and increase the value of property.
It’s too much money.
You’re forced to go to the nicest, newest properties.
There is definitely a plus side to that.
The plus side is you get a lot of new amenities as an operator.
As an owner, you don’t have to do as many repairs.
2. Where is the Margin of Safety?
Warren Buffett has a saying: “Rule number one is don’t lose money. Rule number two is don’t forget about rule number one.”
I’m a big fan of Warren Buffett.
One thing he looks at is if the investment has a margin of safety.
That means you have to look at your downside.
In Class A there’s not as much margin of safety.
Typically in Class A, you’ll hope for 7% to 10% average annual returns.
What we’re really counting on is that the market will continue to appreciate.
What happens if there is a recession?
What happens if rents go down?
What happens if you can’t get the $4,215 month for that two bedroom?
It dramatically decreases the amount of returns.
You might actually be losing money.
There’s more downside in these deals than there is upside – unless everything goes right.
Thank God there is another way!
It’s called value-add multi-family.
3. How Value-Add Deals are Different
Value-add multifamily has the idea that you’re adding value and making things better.
That’s what allows you to see a pop in the value of the property, which dramatically increases your return.
This is how multifamily deals are different:
In a property we have in Jacksonville, Florida, we’ve got about 1500 apartment units with our investors.
Average rents are around $1,000.
Then we do the value-add work of about $6,500 per unit in renovations.
We come in and do floors, countertops, and some appliances – we do a lot of stuff!
After completing that work, we see an increase in the rents by $566.
When you add that to the average rent, the new rent total is $1,566.
That’s a 57% upside! Amazing!
With single family, when you sell your house, it’s worth what a nearby property is worth.
In multi-family, it’s all based on income.
If you can increase the income by 57%, you’re increasing the value of the multifamily property by around 57%.
If we can renovate 80% of 227 units over the next couple of years, we know we’ll see a big increase in the value.
This is called forced appreciation.
There are two types of appreciation.
One is market appreciation, which you see in Class A, B, and C apartments.
What you’re really looking for is forced appreciation.
We’re at $1,000 and want to get to $1,566.
Even if there’s a recession and those rents are $1,450 instead of $1,566, we’ve got a margin that means we’re still doing really well.
We’re still making a lot of money on the increase that we have.
If things keep going up, we’ll do even better!
Instead of returns being around 7% to 10% per year in Class A apartments, we see projections of 14% to 16%.
You get the cash flow from the newer deal, but you also get higher returns.
If you’re getting a 14% to 16% return, that type of return will double your money in around five to seven years.
With a 7% to 10% return, you wouldn’t see that kind of outcome for 10 to 12 years.
You want to have downside protection as well.
This investment allows for downside protection, but it also allows you to maximize what you’re able to get on a deal.
By now you’re probably thinking:
What can go wrong in this?
Why wouldn’t you hold this kind of deal forever?
Warren Buffett even says the best holding period of an investment is forever.
We’ve seen all the value increase.
This may seem counterintuitive, but every year you hold the investment longer than that, your returns per year go down.
That’s why we typically hold for three to five years. Once we’ve added value and seen the big increase in value, it can make sense to sell and move on.
As a quick summary: Class A can go well when things are going well.
Remember that you won’t live there yourself to enjoy all the beautiful amenities.
Investors typically get paid very well to do workforce housing and add value.
Look for opportunities to increase the property value over time.
And lastly, greater margin of safety adds greater value in deals.
Now I want to hear from you!
Do you love Class A?
Do you hate Class A?
Let us know why in the comments below.
Before you leave, make sure to check out our special report about high inflation investing. It shares the best choices to invest during an inflationary environment.
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Disclaimer: I am not your investment advisor. This is for educational purposes only. I am not giving specific advice on what you can do. I am simply giving my opinions.