Taking something old and rundown and breathing new life into it is an exciting adventure. I see it all the time, people take an old car or vintage furniture, put some money into it by fixing it up, updating and improving it, and then resell it at a profit. It’s a genius strategy with benefits for everyone involved. This concept is essentially how value-add investments in commercial real estate work.
Value-add is a commonly used strategy in multifamily (apartment) investing. With a value-add deal, the property is purchased and overhauled in areas that have been previously overlooked, such as curb appeal or shared tenant spaces. The value of the asset is increased and it’s eventually sold for a substantial profit.
Value-Add Real Estate Basics
You’re probably familiar with the fix-and-flip strategy. This is where you buy a single family home in need of repair or cosmetic upgrades, invest your sweat equity by making the needed renovations (that’s the fix), and then sell it for profit, hopefully a significant bitof cash (that’s the flip). The fix-and-flip method rewards your hard work and willingness to take a risk on a diamond in the rough. Then the new owners enjoy an updated, move-in ready home.
Commercial value-add real estate syndication deals work much the same way, just on a massive scale. Rather than one single family home getting renovated over the course of a few months, a multifamily value-add deal involves hundreds of units getting renovated over a few years, or the lifecycle of the project.
An example of a great value-add property is an apartment building with peeling paint, outdated appliances, or overgrown landscaping. The curb appeal of the property isn’t enticing to potential renters and may leave current tenants looking for an upgraded residence. Making simple, cosmetic improvements can attract more qualified renters and increase the income the property produces.
Improvements in value-add properties have two goals. The first is to positively impact tenants by improving the unit and the community. The second goal is to positively impact the investors by increasing the bottom line.
Examples of Value-Add
Value-add renovations can include upgrades to individual units. Here are some improvements commonly made to units in a value-add property:
Fresh paint throughout the unit
New, upgraded cabinets
New countertops
New, upgraded appliances
New flooring throughout the unit
Upgraded light, kitchen and bathroom fixtures
Adding value to the exterior property and shared spaces often helps to increase the sense of community for the tenants. Here are some upgrades known to increase tenant satisfaction and property value:
Fresh paint on building exteriors
New property signage
Landscaping
Dog parks
Gyms
Pools
Clubhouse
Playgrounds
Covered parking
Shared spaces, such as BBQ pits or picnic areas.
Adding value to a multifamily property can also take the form of increasing the property’s efficiencies. Here are some examples of how to make a property more efficient:
Decrease utility costs by adding green initiatives
Shared cable and internet
Reducing overall expenses
How to Plan for a Multifamily Value-Add
The basic concept of how to pull off a fix-and-flip of a single-family home is pretty self-explanatory, but when it comes to hundreds of units at once, the renovation schedule and logistics take a little more research and planning. Oftentimes, people have questions about how to renovate a 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 always tackled first. In a 100-unit complex, say there’s a 5% vacancy rate, that means there are five empty units. The first renovations should start in those five empty units.
After those first five units are complete, each time an existing tenant’s lease comes due for renewal, they are offered the opportunity to move into a freshly renovated unit. As you can imagine, tenants are usually more than happy with the opportunity to move to an upgraded space and don’t mind paying a little extra.
Once tenants vacate their old units, renovations continue, with the process repeating until most or all of the units have been updated.
As expected, some tenants do move away during this process, and it’s important for projects to account for a temporary increase in vacancy rates due to turnover and new leases.
The Benefits of Value-Add Properties
The basic premise of using value-add strategies is to benefit all parties involved. Through renovations, tenants enjoy a more aesthetically pleasing property, with updated appliances and more attractive community space. Improved tenant satisfaction keeps vacancy rates low, making the property more valuable, allowing higher rental rates and increased equity, which benefits the bottom line and investors.
It’s easy to see how the property-beautification process makes the asset more attractive to tenants, but let’s explore why value-add investing is a great strategy for investors.
Yield Plays Explained
To fully appreciate value-add investments, you need to first understand yield plays. Yield plays are when an investor buys a stabilized property and holds it for the monthly cash-on-cash returns and potential future profits.
Yield play investments are where a property is purchased that’s in decent shape and is currently cash-flowing. The property immediately starts providing a recurring stream of income from the rents collected, or the yield. The long-term plan is to sell the asset at a later date for a small profit. With a yield play, there’s no business plan to renovate, force appreciation, improve the asset and realize a larger gain at sale. Yield play investors simply hold the property in anticipation of potential market increases. But unfortunately, there’s always the chance of experiencing a flat or down market instead.
The Potential of Value-Adds
Clearly, value plays and yield plays are different. When investing in a value-add property, significant work and renovations are required to increase the value of the property.
Value-add investments do carry a level of risk, but the potential upside remains very attractive, especially for investors. Through action and hard work that improves the asset and increases its overall value, investors in value-add deals don’t just hold the property and hope for market increases, they force increases by improving the property and giving opportunities to raise rents and lower expenses.
By improving the property, income is increased, which also increases the equity in the deal. This matters, because commercial properties are valued based on how much income they generate, not on comps, like single-family homes. Value-add investments allow investors much more control over the deal than in a yield play.
An ideal real estate syndication deal is a hybrid of yield + value-add. A hybrid deal is where an asset gets improved, cash on cash yields are high and the market increases simultaneously. Investors have increased control thanks to the value-add renovation portion of the deal and the market growth adds appreciation.
Keep in mind as with any investment, there are also risks associated with any value-add deal.
Common Risks in Value-Add Investments
There are risks associated with multifamily value-add investments. The common risks with value-add properties include:
Not being able to achieve target rents
More tenants moving out than expected
Renovations running behind schedule
Renovation costs exceeding initial estimates. Going over budget is a big concern when you’re renovating hundreds of units.
Mitigating Risk
Risk mitigation is of the utmost importance. Make sure to look for sponsors who have capital preservation as a top priority and who have a number of risk mitigation strategies in place. Here are some examples of risk mitigation strategies to look for when evaluating potential deals:
Conservative underwriting
Proven business model
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 during the project.
When done well, value-add investments have great potential for building wealth, however they do come with serious risks. Risk mitigation strategies are crucial in protecting investor capital.
Is a Value-Add Investment Right for You?
As you know, no investment is risk-free. Despite their risks, however, value-add investments remain attractive due to the great benefits provided to the community and investors.
I focus on Class B and C apartment complexes with Value-Add potential here in the DFW Metroplex because I know syndicating these properties will allow me to lead an initiative to improve the vibe, cleanliness, and quality of apartment communities right in my own backyard. With my detailed underwriting and assertive asset management skills, investors and residents for miles around will benefit from my passion for these investments.
Value-add investments lend investors control over how and when renovations are executed, which allows them not to rely solely on market appreciation. Investing in value-add properties provides investors more options when it comes to preserving capital and maximizing returns during the lifecycle of the deal.