The value-add multifamily (“VAM”) business was the darling of real estate investing over the past decade. In a zero interest rate environment where capital flooded the space, it was impossible to do wrong. The more you bought and the more aggressive floating rate debt you used, the better you performed.  What a time!

Things have shifted quickly and the sentiment toward VAM investing has turned negative. The real estate rags and online discourse are littered with outlier distressed situations. In November 2022 the co-founder of a well-known syndicator was featured in Entrepreneur Magazine detailing how he built a $7.5B empire in 3 years, and by August 2023, the same firm has been a punching bag for its financial troubles.

The business plan of that firm and many other high-flying syndicators over the past few years was simple; acquire older vintage multifamily assets in need of modernization, largely ignoring the going-in cap rate, put on high-leverage floating rate debt, renovate as quickly as possible, and sell to the next guy within 2-3 years.

This was a great business, until it wasn’t.   

This strategy was reliant on interest rates staying low and cap rates continuing to compress (or at least not expand). The business plan wasn’t complex, and operators didn’t need differentiated thought or to execute flawlessly to be successful. In other words, there was no way to achieve alpha. 

But the story of these firms is not the story of VAM as a business. I recently got in a LinkedIn debate around the merits of the value-add multifamily business. A well-respected and experienced operator had the following to say.

“We did value-add multifamily for a period of time and the problem is you can’t create any moats around it and it requires almost no specific knowledge as anyone can do it. All you can do is pay more than the next group and that always leads to disaster.”

He went on to say, “there is no real Alpha in value-add multifamily investing as the markets are too efficient now. Heck groups don’t even set their own rents, they use software programs to do that.”

While there is some merit to his statement, value-add multi has a relatively low barrier to entry and is easy to understand on the surface, I disagree with the general sentiment that ‘all you can do is pay more than the next group’ and that ‘there is no real alpha in value-add multifamily investing’.

In order to explore this further we have to start by defining alpha. According to Howard Marks in his memo What it’s all about, Alpha, he exerts that “alpha is the ability to profit consistently from things other than the movements of the market, to add to return without adding proportionately to risk, and to be right more often than is called for by chance.”

Multifamily is a relatively efficient market, but that doesn’t mean alpha can’t be achieved. Marks further describes alpha as a “differential advantage, or skill that others don’t possess. Alpha isn’t knowing something, it’s knowing something others don’t know.”

With that in mind, let’s bring it back to value-add multifamily investing. What makes VAM investing attractive is that it’s highly fragmented and both capital and operationally intensive, characteristics which can lead to sustained outperformance (i.e. achieving alpha).

Capital Intensive: A business that is capital-intensive means operators are reliant on the credit markets and investor psychology to execute deals. Raising capital, especially in times where capital is hard to come by, is no doubt a skill possessed by select operators.

The elements of capital raising which are critical to success and enable the best operators to achieve alpha include:

• Being able to raise capital when the credit markets are frozen and market participants are fearful requires a strong track record, skill, and market expertise/conviction and will enable sophisticated operators to buy deals at an attractive basis (backward looking).  
• Buying at an attractive basis allows owners to be nimble during down periods. If your basis is low compared to the comp set and you have sufficient reserves, it’s easy to pull back rents to maintain occupancy during economic slowdowns.  
• Aligning capital with the intended business plan and maintaining hold period flexibility is key to navigating cycles. The way most groups get hurt is by being forced to sell at the wrong time or over-levering and having debt mature at bad time. This is what we’re seeing with many distressed situations today.  

The ability to successfully execute deals toward the bottom of the cycle (when others are fearful and capital is scarce), align capital with the intended long-term business plan, and maintain flexibility eliminates the major risks of VAM investing and leads to long-term outperformance (alpha).

Operationally Intensive: While there is a general VAM playbook, I firmly believe superior execution can lead to outperformance. Superior execution requires submarket expertise, a deep understanding of the target demographic, and a differentiated approach.

Here are several operational elements which can lead to outperformance:

• Identifying an underserved and/or growing target demographic and designing to that target renter. When executing a VAM deal, you should know exactly who your target renter is so you can be more intentional with your design and amenity choices.

Bobby Fijan nails it with this tweet.

• Taking a resident-first management and operations approach. Outperformance can be achieved by being resident-obsessed and doing everything possible to please and delight them including custom move-in packages and robust programming. Above all else aim to create a sense of belonging. 

Getting operational elements right requires selecting the right management team, hiring and retaining quality onsite staff, and empowering them with the tools and resources to be successful. These are all skills of a high-quality operator.

Timing, buying at an attractive basis, capitalizing properly, and executing well all impact returns. In addition, market and submarket selection matters, refi timing matters, class segment (A/B/C) matters and all impact outcomes.

There are so many variables at play which require skill, expertise, and creativity, and the best operators will outperform over the long run, generating alpha.

If I didn’t believe this to be true, I’d be working in a different business.