It’s immensely satisfying to add value to something mistreated and unloved through your own hard work.
Maybe you’ve done something similar in the past? For example, have you ever upcycled a piece of furniture around your home by giving it a fresh coat of paint or reupholstering it with new fabric, admired it for a few years, then sold it on so someone else could get pleasure from it?
It’s not a complicated principle when you think about it — you added value to an unloved, unused piece of furniture by putting in some hard work and a little time and making it into something desirable to someone else.
Value-add in real estate works on precisely the same principle, and it’s a hugely popular way to invest.
Understanding Value-Add Real Estate
You’re familiar with the term fix-and-flip; buy a tired single-family home, renovate it, then sell for a profit. As have many other real estate investors, we’ve done it before — it’s a win-win because your hard work and vision get you a significant financial return. In addition, the new owner receives a beautifully remodeled home that they can enjoy.
Value-add multifamily real estate deals follow the same principle but on a much bigger scale. The investment means that hundreds of units can be remodeled over a pre-defined number of years instead of one single-family home over a few months.
Spotting the perfect value-add property takes skill. First, investors have to look past peeling paint, outdated appliances, and horrible landscaping that totally wrecks a property’s curb appeal into the bones of the building. Of course, renters don’t want to move into a dilapidated, unloved building, but with just a few tweaks and simple upgrades, the investors can create units that attract more qualified renters willing to pay substantially higher rents.
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)
Way to Add Value to a Property
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 Multifamily Value-Add Process
The basic fix-and-flip of single-family homes is pretty familiar to most people, but the renovation schedule and logistics aren’t as intuitive when it comes to hundreds of units at once. Questions arise around how to renovate property while people live there and how many units can be improved at a time.
When renovating a multifamily property, the vacant units are first. For example, 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 glad 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 projects need to account for a temporary increase in vacancy rates due to turnover and new leases.
Why Value-Add Properties are a Great Option
When done well, value-add strategies benefit all parties involved. For example, we provide tenants with a more aesthetically pleasing property, updated appliances, and more attractive community space through renovations. 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 an excellent strategy for investors.
The Yield Play
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 in decent shape is purchased. The property provides a recurring income stream 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 more significant 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.
How are Value-Adds Different?
Value plays and yield plays are different. For example, in a value-add investment, significant work (i.e., renovations) increases the property’s value, and making such improvements carries a level of risk.
However, value-add deals also have 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 keep the asset hoping for market increases. Instead, 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 revenue 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 control 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.
Are There Risks 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)
Strategies for Risk Mitigation
When evaluating deals as potential investments, look for sponsors who have capital preservation at the forefront of the plan and who have several 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 essential – to protect investor capital at all costs.
Positive Impact on Communities and Investors
We love investing in commercial value-add real estate syndications because of the long-lasting benefits for both tenants and investors. We genuinely believe that what we can do to provide clean, bright, safe homes to a community fulfills our personal vision of building a worthwhile legacy.
Of course, we select the right value-add investments and mitigate risks as much as possible so that we also benefit from beautifying a previously uncared-for building. We also ensure that, as investors, we have a say in how renovations are executed so that we’re doing the best we can for renters while also safeguarding investors’ capital and maximizing returns.