Co-Living: A Powerful Strategy
Investors are Beating Uncertainty with a New Investment Model
By Frank Furman
For the past decade, single-family real estate investors have benefited from a seemingly iron-clad law that a property you buy today will be worth even more tomorrow. Low interest rates and eager lenders have saved many, many marginal deals.
How disciplined does your underwriting and valuation need to be when the most common lament you hear from investors is “I wish I’d bought more”?
Today, uncertainty reigns. Interest rates are up and poised to go higher. Planned rent increases in every proforma aren’t looking as easy to pass through. Seemingly overnight, some of the boldest operators have found pause. But the fundamentals of real estate haven’t changed overnight, only the need to apply those fundamentals with more discipline than was required yesterday. Savvy investors pair creative strategies with those fundamentals to create value where others can’t.
Co-living has emerged as a powerful strategy to do just that. The model offers:
» Yield // Increased cashflow and yield for the same asset
» Counter-Cyclicality // Recession-proofing is built in
» Differentiation // Fewer operators offer the model
While the model offers an alternative way of evaluating an asset, the fundamentals are entirely the same. Yield is simply the net profit over the cost basis, what changes is the revenue potential, expenses, and cost basis.
Optimizing Revenue
Top-line revenue potential for a traditional asset is driven as much by location as its underlying attributes. The spread between one-bedroom and three-bedroom apartments at a complex is small relative to the rent differences between complexes. With location (and all the associated attributes, such as school district) fixed, investors are hard-pressed to truly add value to assets.
In co-living, the revenue-generating unit is the bedroom, so the spread between a three-bedroom house and a six-bedroom house across the street is effectively double. By capturing and monetizing underutilized space (such as an unfinished basement or a formal dining room), investors can dramatically improve revenue potential within the existing footprint. In a recessionary environment where rent increases flatline, investors will need to think more creatively than simply increasing the rent growth assumptions in their model to boost yields.
Expenses
Expense underwriting is often a stumbling block for investors considering alternative strategies such as short-term rentals or co-living due to both variability and magnitude. For example, in a traditional single-family residential (SFR) business, utilities are of little concern both when acquiring and when operating the property. An inherent conflict also exists in the arrangement. The investor isn’t incentivized to invest capital expenditures (CapEx) in efficiency because the tenant pays for the usage, and the tenant won’t invest in CapEx because they don’t own the property. So, utility bills are higher than they ought to be, despite it being in the interest of both landlord and tenant for as small a portion of tenant earnings to be so dedicated.
In both co-living and short-term rentals, the paradigm is shifted, with the investor footing the utility bills despite the usage being incurred by tenants and guests. This forces investors to include utility bills in their underwriting, estimating usage across services as varied as Wi-Fi and sewer in all four seasons. Fortunately, this is another opportunity for incremental value, as many simple fixes such as low-flow fixtures and smart thermostats can dramatically cut usage at a very reasonable cost. Many online tools make this process easy, and it’s a critical skill set to develop.
Repair and maintenance (R&M) underwriting is similarly overlooked. Most proformas simply assign, say 2% of revenue to R&M costs and hope that anything outside that box will be covered by insurance or passing through egregious costs to tenants. While this may work in aggregate, it belies the snowball effect of such expenses. When times are good, tenants are happy, revenue is high and maintenance expenses are low. When the opposite is true and tenants are unhappy and overworked property managers add trip charges or fall behind, revenue suffers as tenants withhold payment and even more complaints add to the spiral. The costs of turning a whole house after a tenant moves out can easily wipe out the earnings of the past year for the property.
The difference in a co-living context is that by diversifying within a property, generally with slightly shorter tenures, your overall variability is reduced. As a rule of thumb, R&M costs are about double what is underwritten for the same property rented traditionally for two reasons: services such as landscaping and cleaning services add to baseline R&M costs, and with several people in each house, there’s a steady stream of minor issues. However, by managing move-outs on a per-room basis, say, once every other month, rather than turning the whole house every other year, turn costs are both lower and flatter over time.
The counter-intuitive insight is that the underwriting can be simpler and more predictable than for a traditional rental. The result is that for the right kind of property, using the same fundamental pro-forma you’d use for a traditional rental, you can engineer double your yield in a way that that other investors are just getting around to understanding.
Cost Basis
While evaluating assets you already own, it’s important not to leave out the investment required to operate a co-living property, be it additional locks for interior doors or furnishings. While the payback should be rapid, the costs are real. When evaluating a possible acquisition, the same process applies. While the costs will vary from house to house, it’s prudent to budget at least $10k for furnishings and other improvements.
Investors can take heart in that there are few truly new real estate ideas and even fewer truly new market conditions. Short-term rentals seem as if they’ve taken the world by storm, but small proprietors have managed bed and breakfasts and inns for literally thousands of years. Co-living, far from being some millennial-focused experiment, is nearly as old, and indeed was the primary mode of independent living for singles as recently as 50 years ago.
These paths are well-worn, trodden by operators who have learned the lessons and made the mistakes so you don’t have to re-learn and re-make them.
Resources abound, such as this co-living pro forma tool (www.padsplit.com/earnings-calculator), and there are active communities engaged in these pursuits in every US market.
Learn. Explore. Experiment. And if you’re told that an investment is going to follow different fundamental rules than the ones you already know, run away.
