Imagine that you spot an old cabinet unit sitting out on the curb. You stop to take a look, and since it’s in good shape, you load it up and take it home to give it a fresh coat of paint.
A few years later, you sell the cabinet to someone else who sees it and has the perfect place for it.
You took something that had been overlooked, saw its potential, committed some effort to it, and gave it new life. This is the essence of value-add, which is a commonly used real estate investing strategy.
The Basics of Value-Add Investing
The process of buying a run-down single-family property, remodeling it, and selling it for profit is commonly referred to as a fix-and-flip, or just a flip. Your sweat equity and ability to see a diamond in the rough is rewarded with higher rents, and the new owner gets an updated, move-in ready home.
Value-add multifamily real estate deals follow a similar model, but on a much larger scale. Dozens or even hundreds of units get renovated over years at a time instead of just one single-family home over a few months.
A great value-add property may have peeling paint, outdated kitchen and bathroom cabinets, or overgrown landscaping, which all affect the curb appeal and the initial impression potential renters will form. Simple cosmetic upgrades can attract more qualified renters and increase the income the property produces.
The improvements in value-add properties have two goals:
1) To improve the unit and the community (positively impacting tenants)
2) To increase the bottom line (positively impacting the investors)
Examples of Value-Add Work
Common value-add renovations can include individual unit upgrades, such as:
- Fresh paint
- New cabinets
- New countertops
- New appliances
- New flooring
- Upgraded fixtures
In addition, adding value to exteriors and shared spaces often helps to increase the curb appeal and sense of community:
- Fresh paint on building exteriors
- New signage
- Dog parks
- Covered parking
- Shared spaces (BBQ pit, picnic area, etc.)
On top of all that, adding value can also take the form of increasing efficiencies:
- Green initiatives to decrease utility costs
- Shared cable and internet
- Reducing expenses
The Renovation Schedule for a Value-Add Property
The process of flipping single-family homes is pretty familiar to most people, but when it comes to hundreds of units at once, it’s not as intuitive. How do you renovate the property while people are living there, and how do you know how many units can be improved at a time? Well, there are a couple ways to do it.
One way, sometimes referred to as a “deep value-add,” is to vacate a large percentage of the property and renovate it all at once. This might mean one building at a time for an asset with several buildings. This method drops below “stabilized” occupancy levels, so it’s usually only used when doing a heavy amount of work to both the unit interiors and building exterior that aren’t feasible or practical while tenants are living in the building. This method is riskier, and the business plan has to account for dropping the occupancy rates way down while the renovations are performed.
The more common method (the one we look for) is to renovate empty units as
they come available, which lets you keep occupancy high – typically above 90%.
In a 100-unit complex, a 5% vacancy rate (which is common) means there are
five empty units (or 10 empty units in a 200-unit complex). These are where renovations begin.
Once those units are complete, as other tenants’ leases comes due for renewal, they are offered the opportunity to move into a freshly renovated unit. Tenants are usually more than happy with the upgraded space and happy to pay a little extra.
Once tenants vacate their old units, they’re renovated too, and the process continues to repeat until most or all of the units have been updated.
During this process, some tenants do move away, and it’s important for projects to account for a temporary increase in vacancy rates due to turnover and new leases.
When units are updated, the market rents are increased to be competitive with a similar-quality unit at competitors’ apartments (i.e., rental comps).
Why We Love Investing in Value-Add Properties
When done well, value-add strategies benefit all parties involved. Through the renovations, we provide tenants a more aesthetically pleasing property with updated finishes and appliances and more attractive community spaces. By
doing this, the rental rates grow. This, in turn, increases the net operating
income, which increases the overall value of the property. This means the owners’ equity in the property (i.e., the value of the investments in it) grows too, which makes the investors happy, since the equity will be paid out to them when the property is sold.
The property improvement process and the fact that renovated property is more attractive to tenants is probably straight-forward. But let’s dive into why value-add investing is a great strategy for investors.
But Let’s Talk About Yield Plays First…
To fully appreciate value-add investments, we must first understand their counterparts, yield plays. In a yield play, investors buy a stabilized asset and hold it for (potential) future profits due to market growth.
Yield play investments are where a currently-cash-flowing-property that’s in decent shape is purchased and held in hopes to sell it for profit, without doing much to improve it besides maybe some management efficiencies to reduce expenses. Yield play investors hold property in anticipation of potential market increases, but there’s always the chance of experiencing a flat or down market instead.
In a yield play, nearly everything is dependent upon the market. This may be profitable when the market is growing, but it becomes riskier the closer to the top of the market cycle you get.
Now, Let’s Get Back to Value-Adds
Value plays and yield plays are the opposite. In a value-add investment, significant work (i.e., renovations) takes place to increase the value of the property, and doing such improvements can carry a significant risk.
However, value-add deals also come with a ton of potential upside since the investors hold all the cards. Through physical actions that improve the property and increase its value, value-add investors don’t just hold the asset hoping for market increases – they directly force it to appreciate.
Through property improvements, income is increased, thus also increasing the equity in the deal (remember, commercial properties are valued based on how much income they generate, not on comps, like single-family homes), which allows investors much more control over the investment than in a yield play.
Of course, a hybrid yield and value-add investment is ideal. This is where an asset is improved as the market increases simultaneously. Investors have control over the value-add renovation portion, and the market growth adds appreciation. Just keep in mind that the market growth isn’t guaranteed.
But before you get too excited about the potential of a hybrid investment, remember that there are risks associated with any value-add deal.
Examples of Risk in Value-Add Investments
In multifamily value-add investments, common risks include:
- Not being able to achieve target rents
- More tenants moving out than expected
- Renovations running behind schedule
- Renovation costs exceeding the initial estimates (which can be a big issue when you’re renovating dozens or hundreds of units)
When evaluating deals as potential investments, look for sponsors who have capital preservation at the forefront of their plan and who have a number of risk mitigation strategies in place, such as:
- Conservative underwriting
- Proven business model (e.g., some units have already been upgraded by the seller and are achieving target rent increases)
- Experienced team, particularly the project management team
- Multiple exit strategies
- The budget for renovations and other capital expenditures is raised up front, rather than through cash flow
Value-add investments can be powerful vehicles to build wealth, but they also come with serious risks. This is why risk mitigation strategies are important – to protect investor capital at all costs.
No investment is risk-free. However, when a strategy provides great benefits to the community AND investors, and better returns to investors than yield-play investments, it becomes quite attractive, despite the risks.
Properly leveraging investor capital in a value-add investment facilitates major improvements in apartment communities, thereby creating cleaner and safer places to live, as well as making tenants happier.
And because investors have control over how and when renovations are executed, rather than relying solely on market appreciation, they have more options when it comes to safeguarding their capital and maximizing returns.
Sounds like a winning deal!
Further Reading: Exploring Projected Returns in a Real Estate Syndication