Is it Worth It? The Benefits of Investing in Better Quality Deals Over Value Add Opportunities

What are the main operational risks in multifamily real estate deals?

1.) Property management

To make it quick, you'll find that most of the best property managers would prefer to do A class deals over C class deals because of the vast difference in work required. Both pay similar rates.

2.) Unexpected Capex

A large percentage of multifamily deals 100 units and up are syndicated or bought with a 5 year business plan in mind. What this creates is a short term mindset to how they will treat the property. Instead of spending the money to fully replace large non-recurring expenses, they'll settle on the cheaper "patch" that may last another 5 years. The metaphorical 5 year can gets kicked down the road over and over. On C class properties that are 50 years old, this has been done over and over. Eventually someone is going to get stuck with the massive non-recurring expense that could break the business plan.

To account for this, I see other C class operators I've seen budget for an excess of 10% of the purchase price in total reserves. On newer properties, you would likely only need half that amount held in reserve. A higher initial investment not only is harder to raise, it also dilutes returns just to maintain the same level of safety that an A class asset would provide.

3.) Financing

Because of the generally more predictable qualities of the A class asset, lenders often will give more favorable terms to high quality A class deals than unpredictable C class deals. Better loan terms could involve things like having full term interest only, lower rates, higher loan proceeds, etc.

Conclusion:

Every deal can work if you have the right expertise, buy at a good price, location, and with good financing. This can be across any property class. The value add play is what people tend to focus on because it's what sells the deal. However, the non-recurring expense risks can often be overlooked when buying older properties that are marketed as value add opportunities.