DW Capital

Value-Add 101

David Weinstock — Fri, 24 Mar 2023 21:32:06 +0000

The words “value add” shows up a few places on our website and if you search for “value add multifamily” on the internet, you’ll get dozens of articles and companies investing in or selling real estate. What is a “value add” project? In simple terms, we take an existing building and “add value” to it by improving the property.

However, that in itself doesn’t actually move the bar since what really matters is how the property is valued by others (i.e. banks and ultimately a new future buyer).

In typical residential real estate, the value of that property is based on what other similar types of properties near you have sold for and are expected to sell for today, known as “comparables” or “comps”. So, if you live in a neighborhood of similar houses with similar sizes, they would be expected to be worth about the same.

However, in the commercial world, the valuation of a property is heavily dependent on the income it generates, also known as its net operating income (NOI), which is the same term for the bottom line profit in an operating business (since commercial real estate IS essentially an operating business you are buying!). The combination of the NOI and a market “Cap Rate” are used to determine the price of an asset. This is why two buildings next to each other could sell for 2x the price of the other one if one generated significantly higher income.

Since the net operating income of a property is in our control (you can renovate units that will command a higher rent, reduce utility expenses by becoming more energy efficient, or do a myriad of other things that either increase top line revenue or decrease costs. This results in positive changes in the net operating income of the building). Therefore, through your own efforts, you can “force” appreciation in the value of the property by increasing your profitability (i.e. a higher NOI)

The last piece to this puzzle is to know the market “Cap Rate”, which is a proxy for valuing similar assets in a given area (i.e. Class A multifamily in the greater Atlanta area). Once you know the Cap Rate (most large brokers can run reports to estimate this for you or you can research on your own), you can then estimate the potential increase in value based on the improvements you make in NOI.

For example:

DW Capital buys a property for $2,000,000 that generates $100k per year:

Cap Rate = NOI / Price
Cap Rate = 100,000 / 2,000,000
Cap Rate = 0.05 (5%)

Through our value add program, we renovate kitchens and bathrooms, and rebrand and re-lease the apartment at higher market rates. This raises our NOI by 20% yielding 120k per year instead of the prior 100,000 when we bought it.

New Price = NOI / Cap Rate
New Price = 120,000 / 0.05
New Price = 2,400,000

… and that’s how we add value and generate returns for investors.

Leverage vs. Cash

David Weinstock — Fri, 24 Mar 2023 21:28:52 +0000

Here is your quick tip for the day: Among all the benefits real estate provides for investors and owners, I believe one of the most important and valuable ones is the use of leverage and how it impacts your ultimate returns.

Using debt to buy real estate is an accepted and very common practice. Many loans are in fact backed by the full power and authority of the US Federal Government and as of last check, the federal government now invests in or insures over 90 percent of mortgages in the U.S. via Fannie Mae, Freddie Mac or Ginnie Mae.

So, what’s the big deal about leverage?

Let me illustrate the power of leverage – We will perform a simple investment comparison between an all cash purchase of a property and one purchased with a loan (with “leverage”, i.e. you are buying the whole asset but are able to use the banks money to pay for the majority of the purchase by only providing a down payment to secure the property and the loan).

Scenario: You wish to purchase an investment property worth $500k today. You expect that over the next 5 years the value will go up a total of 10% (~2% annually).

If you purchase with cash:

Purchase price: $500k
Capital invested: $500k
Profit: $50k (10% of the purchase price)
Total Return = $50k/500k = 10%

However, if you purchase with leverage:

Purchase price: $500k
Capital invested: $100k (20% down payment vs. the entire purchase price; rest financed with a mortgage/loan)
Profit: $50k (the property still goes up only 10%)
Total Return: $50k/100k = 50%!

This lets your investment dollars go farther. Since you only put down a portion of the total sales price, for every increase in the value of the overall asset, that grows at a significantly larger factor than the initial leveraged capital that went in to begin with.

“Accredited Investor” vs. “Sophisticated Investor”

David Weinstock — Wed, 15 Feb 2023 20:50:05 +0000

What does it mean to be an “Accredited Investor” vs. a “Sophisticated Investor” and why are some offerings subject to being one or the other to participate?

From a high level perspective…

When we look to raise capital from investors, these activities will fall under the oversight of the United States Securities and Exchange Commission (SEC). There are certain rules and definitions that need to be adhered to in order to contact individuals and raise capital from certain types of investors. Depending on the type of capital raise, only certain types of investor profiles may be legally allowed.

One way the SEC protects potential investors is through the creation of rules that regulate who can put their money into complex financial offerings such as Real Estate Investments, Venture Capital, etc. So while anyone who has the cash to invest in stocks, bonds, or mutual funds can do so without many hurdles, the bar is higher for more complex investments such as larger commercial real estate.

So, what is an Accredited Investor?

For individuals who have been investing in syndications or other substantive real estate transactions, you may already be familiar with this term. The basic definition of an Accredited Investor is someone who is:

An individual earning more than $200,000 in annual income for at least two years
A married couple with more than $300,000 in annual income
A household with more than $1 million in assets (not including their personal residence)

An accountant, third party verification service, or by providing financial information is usually required to confirm this status prior to an investment.

What about a Sophisticated Investor?

This is more subjective. It is defined as someone who has “sufficient knowledge and experience in financial and business matters” to make them capable of evaluating the merits and risks of a prospective investment. These are individuals who have a reasonable expectation of understanding a complex transaction, such as an investment in a real estate syndication, where they may not yet have the same financial qualifications as an accredited investor. These individuals may have business ownership experience, have transacted in private investment transactions on their own, etc.

Before raising your hand to invest in any deal, it is important to know what kind of capital raise is being performed — the most common being a 506(b) or a 506(c) with the bottom line being to remember that Sophisticated Investors are only able to participate in 506(b) offerings and there is a limit on the number of spaces available for sophisticated investors in a raise. These spots may go quickly if provided.

If you are an Accredited Investor, there are many more opportunities and choices of offerings.

The Anatomy of a Deal

David Weinstock — Wed, 15 Feb 2023 20:48:11 +0000

It’s easy to get caught up in the buzz on a new deal once it gets announced. In our quest to continue to educate investors and be transparent in how we view and operate our projects, we wanted to share a few things to keep in mind that many folks don’t call out when you are reviewing a new opportunity and they are looking for you to decide to invest!

1. Returns are not guaranteed

Similar to most investments, the returns shown in an investment summary are a projected return based on how a sponsor expects the project to perform. Most sponsors stress test their deals by performing a series of “what if” scenarios that highlight an average, above average, and below average return scenario to help inform their projections. These scenarios should be based on real market data and accurate assumptions on rents, expenses, and take into account the existing performance of the property as a baseline to improve upon.

Since most deals operate over multiple years, you can expect some variation in the returns and expect the projected returns shown on a deal are their best approximation of how they expect the deal to perform…. but it is not a guarantee it will return the exact number stated.

2. Preferred Return is not the same as Cash on Cash Return

Preferred Returns are about prioritizing cash flows from a project to investors. It is not a measure of a direct “cash on cash” return. A preferred return provides a portion of any active cash flows to the investors first, before sharing any profits with the General Partners. However, if there is not enough cash flow to support the full return, it will accrue and get paid out once sufficient cash has been accumulated.

As a quick example, if a sponsor is projecting a 6% preferred return, this does not mean the limited partners (LPs) will earn 6% on their capital every year. It means the limited partners will receive a 6% return BEFORE the cash flows are split between the GPs and LPs.

3. The Projected Holding Period can be variable

Sponsors are constantly keeping an eye on the market and determining when the best time to exit a project will be. It is common practice to underwrite a project with an assumption for a 5, 7, or 10 year hold period to complete their business plan. However, if the project does extremely well and can pay investors their expected return or higher in an earlier timeframe, they may make a decision to exit sooner. Conversely, if there is a major market hiccup, they could also decide to hold longer until the market stabilizes if they believe that is also in the best interests of their investors. Most operators try to hold to their planned timeframes but investors need to be aware the market may dictate an earlier or slightly later exit depending on what is happening in the greater real estate markets.

1031 Exchange

David Weinstock — Tue, 31 Jan 2023 21:47:24 +0000

1031 exchanges can be a useful tool for real estate investors because they allow the investor to defer paying capital gains tax on the sale of a property and potentially reinvest the proceeds into a more valuable or income-generating property. It’s important to note that there are strict rules and deadlines that must be followed in order to qualify for a 1031 exchange, and it’s always a good idea to seek the advice of a tax professional before pursuing one.

Did you know you can do a tax deferred “exchange” of one property into a larger property (or a piece of a larger property) such as an apartment complex? If you are thinking of selling an existing property and are interested in exploring a tax deferred exchange, please reach out – we may be able to help you place that capital tax deferred into one of our future apartment deals!

What is a 1031 Exchange?

A 1031 exchange, also known as a like-kind exchange, is a tax-deferred exchange of property that is used for business or investment purposes. It allows an investor to sell a property and defer paying capital gains tax on the sale by reinvesting the proceeds into a similar property.

To qualify for a 1031 exchange, the properties being exchanged must be “like-kind.” This means that they must be of a similar nature or character, even if they are not of the same exact kind. For example, a small rental property could be exchanged for a larger commercial property which could be an apartment building, industrial building, or other property used for commercial investment. The important piece is both properties are used for business and/or investment purposes.

In order to complete a 1031 exchange, a specific set of steps must be followed:

Identify the property that you wish to sell (the “relinquished property”) and the property that you wish to acquire (the “replacement property”) within the required time frame. You typically have up to 180 days from the day you sell your initial property to the closing date on a replacement property.
Use a qualified intermediary (QI) to facilitate the exchange. The QI holds the proceeds from the sale of the relinquished property and uses them to purchase the replacement property.
Complete the sale of the relinquished property and the purchase of the replacement property within the required time frame.
Meet all the requirements for a valid 1031 exchange, including the requirement to reinvest all of the proceeds from the sale of the relinquished property.

1031 exchanges can be a useful tool for real estate investors because they allow investors to defer paying capital gains tax on the sale of a property and to potentially reinvest the proceeds into a more valuable or income-generating property.

There are two important caveats to highlight for someone pursuing their first 1031 exchange so that they know what they are getting into:

1. On the plus side (although morbid to highlight), if you have continued to ladder up the value of your properties and defer the gains with multiple 1031 exchanges over time, then upon death, your heirs will receive the properties tax-free at the stepped up basis, making this an incredibly powerful tool to build generational wealth.

2. On the negative side, if you sell a future exchanged property and do not use a future 1031 exchange to continue to defer the capital gains, you may need to pay those combined deferred gains all at once. However, by deferring gains you may also have the growth of the properties to surpass any taxes due which may be viewed as still directionally accurate in building wealth.

What is real estate syndication?

David Weinstock — Tue, 31 Jan 2023 16:21:25 +0000

DW Capital may pool multiple investors together in order to purchase a specific property or set of properties. One way to pool multiple investors together is through real estate syndication.

The Power of Leverage

David Weinstock — Tue, 31 Jan 2023 16:16:44 +0000

Although there are the rare few that have done well picking individual stocks in the stock market, the reality is real estate offers the most potential for significant wealth development for the average investor.

A few things to keep in mind:

Real Estate is a hard asset; It consists of physical assets such as the land it is built on and the building itself. There is intrinsic value to this (even with fluctuations in the market and regardless of the income it generates)
Real Estate that is leased out to others has income that covers its expenses. Changes to its value does not change its ability to pay its bills.

Due to the above, banks look at lending on real estate as a relatively low risk endeavor. Given the volume of loans made every day, very few on the large scale ever default and require the bank to take back the property— and if they do, the bank can sell since it is a hard asset and has intrinsic value. Add to that fact, the majority of large loans are backed by the US Government. Try that next time you are trading stocks on margin!

So on to our story and a tale of two investments that illustrate the power of leverage:

A tale of two investments…

Jim works for a large, stable company that pays $80,000 a year for 30 years. During his time working, he puts away 10% into a retirement account each year. His retirement savings averages a return of 8% when spread out over 30 years and compounds nicely. When Jim is ready to retire, he will have about $1.2M.

Jessica works at the same company and makes the same salary of $80,000 a year. However, she takes the same 10% ($8,000 a year) of her income and invests it into a new rental property every 2 years. After two years, she takes the $16,000 and buys a two-unit standalone building (i.e., a duplex or “2-family”) in a southeastern state worth $80,000. Because she’s buying a hard asset and banks are willing to loan her money to do so, she can purchase an $80,000 asset with only 20% down, i.e. the $16k of savings from each year.

Now in Jessica’s case, let us assume she benefits from cash flow of 8%, appreciation each year at 3%, her tenants are paying down her debt (her mortgage), and she gets tax savings through depreciation on any gains!

So, in the worst-case scenario, after the same 30-year period, Jessica still has a similar $1M in cash but now she also owns the properties free and clear, which is worth double what she paid for them, and has a passive income stream from the properties for as long as she keeps them.

Where We Come In

At DW Capital, we look to purchase “value-add” properties that have an existing cash flow stream so that they are above break even from day one. Then, by implementing our value add plan, we increase the cash flow and overall value of the properties providing our investors a good return from start to finish.