Imagine as you are driving home, you spot a pair of end tables with a free sign at the end of a driveway. You quickly pull over to take a closer look. The tables are interesting but a bit worn. You like them, so you take them home. After some cleaning, and a fresh coat of stain, they look great, and you set them up in your living room.
After a few years, you replace your furniture and decide to sell those end tables to your friend.
You took those tables, put some work into them, gave them a new purpose, and made some cash when you sold them. This is basically how value-add works in real estate investing.
The Foundation of Value-Add Real Estate
With single-family homes, the “fix-and-flip” is a regular practice. You buy a neglected property, make some upgrades, and flip it for a profit. You’re rewarded for your efforts financially, and the new homeowner gets a nicely remodeled home.
The value-add strategy for multifamily real estate works in much the same way, just on a much bigger scale. One single-family home may take a few months to upgrade, while a large apartment complex will take a few years to complete.
The perfect potential value-add complex may need new paint, updated appliances, or new landscaping to help improve curb appeal. Small improvements can attract better tenants and produce a higher income.
In value-add properties, improvements have two goals:
- To improve the unit and the community (positively impact tenants)
- To increase the bottom line (positively impact the investors)
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 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 Logistics of a Multifamily Value-Add
The basic fix-and-flip of single-family homes is pretty familiar to most people, but when it comes to hundreds of units at once, the renovation schedule and logistics aren’t as intuitive. Questions arise around how to renovate property while people are living there and how many units can be improved at a time.
When renovating a multifamily property, the vacant units are first. In a 100-unit complex, a 5% vacancy rate means there are five empty units, which is where renovations will begin.
Once those five units are complete and as each existing tenant’s lease comes due for renewal, they are offered the opportunity to move into a freshly renovated unit. Usually, tenants are more than happy with the upgraded space and happy to pay a little extra.
Once tenants vacate their old units, renovations ensue, 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.
Why We Love Investing in Value-Add Properties
When done well, value-add strategies benefit all parties involved. Through renovations, we provide tenants a more aesthetically pleasing property, with updated appliances and more attractive community space. By doing so, the property becomes more valuable, allowing higher rental rates and increased equity, which makes investors happy too.
The property-beautification process and the fact that renovated property is more attractive to tenants is probably straightforward. But let’s dive into why value-add investing is a great strategy for investors.
First, Yield Plays
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 the monthly cash flow and potential future profits.
Yield play investments are where a currently cash-flowing property that’s in decent shape is purchased. The property provides a recurring stream of income from the rents collected – the yield. There is obviously a hope to sell it at some later date for a small profit, but there is no business plan to renovate, force appreciation, improve the asset and realize a larger gain at sale. 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.
Now, Let’s Get Back to Value-Adds
Value plays and yield plays are different. In a value-add investment, significant work (i.e., renovations) takes place to increase the value of the property, and doing such improvements carry a level of risk.
However, value-add deals also come with a ton of potential upside since the investors hold all the cards. Through physical action steps that improve the property and increase its value, value-add investors don’t just hold the asset hoping for market increases, they force increases through improving the asset, raising rents, and lowering expenses.
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 + value-add investment is ideal. This is where an asset gets improved, cash on cash yields are high and the market increases simultaneously. Investors have control over the value-add renovation portion and the market growth adds appreciation.
Now, before you get too giddy about the potential of a hybrid investment, 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 initial estimates (which can be a big deal when you’re renovating hundreds of units)
When evaluating deals as potential investments, look for sponsors who have capital preservation at the forefront of the plan and who have a number of risk mitigation strategies in place. These may include:
- Conservative underwriting
- Proven business model (e.g., some units have already been upgraded and are achieving rent increases)
- Experienced team, particularly the project management team
- Multiple exit strategies
- The budget for renovations and capital expenditures is raised upfront, rather than through cash flow
Value-add investments can be powerful vehicles of wealth, but they also come with serious risks. This is why risk mitigation strategies are important – to protect investor capital at all costs.
Why Value-Add is a Powerful Investment Strategy
We already know that every investment has some degree of risk. It’s true that value-add investments hold a greater element of risk than already renovated properties. However, the opportunity to be a part of something that greatly benefits the local community as well as investors is most times well worth the risk.
in value-add investments, we leverage investor capital by renovating the property and making improvements to the surrounding area. this creates safer, cleaner communities, in turn making for happier tenants.