September 28, 2022
One of the single best multifamily real estate value-add strategies from an ROI perspective (maybe the only perspective for value add) has to be the addition of a bedroom to a unit — particularly converting a 2-bed to a 3-bed.
This comes with a big caveat of course, which is that such a conversion is not feasible in most units. But if the unit has enough square footage, and the conversion process is relatively straightforward, it may be unmatched dollar for dollar. In this article, we will discuss a multifamily value-add case study that will allow you to understand more about bedroom additions and how to maximize your ROI from this value-add.
The answer is simple – supply and demand.
I am most familiar with the DFW market, so I will limit my discussion to that area. However, I have little doubt that similar dynamics are playing out in many other US markets. The fact is that most B and C class product in DFW, built in the ’70s and ’80s, was not constructed with many 3-bed units.
I wasn’t around at the time, but presumably, the market did not have strong demand for those floor plans. It may be that most families bought or rented single-family houses once they reached a certain size. That was certainly a much more affordable option than it is now.
Real estate values have vastly outstripped income growth for working-class families over the last decade. Moreover, buying a house is no longer a possibility for many. Even renting a house is out of reach for some due to rent growth also outstripping income growth.
That leaves apartments as the best option for many families. We have seen this dynamic play out in the apartment industry as a whole, especially after the great recession, when many homeowners lost their homes to foreclosure and became renters by necessity.
So if demand is so high for 3-bed units, why aren’t developers including more of them in new buildings? The fact is that almost all new construction is an A-class product. I’m not a developer, but my understanding is that construction costs have increased to the point where it is no longer profitable to build affordable housing.
Most renters in A-class buildings are singles, couples, or young families. Since these renters are higher income, they can generally afford to buy (or at least rent) a house once their family grows to the point that it requires more space. Therefore, there is likely little demand for 3-bed units among this class of renters. That leaves an essentially fixed supply of 3-bed units in the older B and C class product.
As we know, normally rent per square foot decreases as total square footage increases. However, the demand for 3-bed units is so strong in many submarkets of DFW that they can command higher rents per square foot than smaller 2-bed units.
For example at our property, our converted 3-bed units rent for about $1.33/sq. ft. vs. $1.17/sq. ft. for the unconverted 2-bed units of the same size. The dollar premium is about $150/month for the converted units.
Now let’s look at how this affects ROI.
Your ability to implement a conversion depends heavily on the existing floor plans. You need enough square footage so that the additional bedroom doesn’t eat up all the living space, and you need a layout that is conducive to the extra room. Below is a townhouse floor plan at our property with an ideal layout for such a conversion.
The dining room is already essentially a separate room, and it was even being used by most tenants as a bedroom. All that was required to convert it was to add a wall with a door, and a closet. This conversion cost about $1,000-$2,000 per unit.
Now let’s calculate the ROI.
We are currently achieving a $150 rent premium for the converted units, which is $1,800 per year. So even at the high end of the conversion cost, we are almost recouping our investment in one year, and we are adding $1,800 to our NOI. But of course, the full ROI is realized on a capitalized basis.
Assuming a CAP rate of 7%, the calculation is as follows:
$1,800/.07 = $25,714.
So for an investment of about $2,000, we can achieve a return of $25,714 at the sale, not counting the additional cash flow we earn along the way. That represents almost a 13x ROI or 1,200%.
Let’s compare that to a normal unit upgrade. An upgraded unit may command a similar premium to the conversion — say $150 — but the cost is much higher. At a cost of $5,000, the upgrade produces an ROI of about 5x. Certainly, nothing to sneeze at, but less than half the ROI of the conversion. In our case, we did both the conversion and the upgrade because the units required full renovations regardless.
Given the outsized returns to bedroom additions, it obviously makes sense to seek out deals that have this potential. I have found that these deals are few and far between — e.g., our property has the potential to convert only 12 out of 172 units. However, if you do find one you may be able to unlock a tremendous amount of hidden value that may not be readily apparent to others.