- The Basics of Value-Add Real Estate
- The Logistics of a Multifamily Value-Add
- Why I Love Investing in Value-Add Properties
- First, Yield Plays
- Now, Let’s Get Back to Value-Adds
- Examples of Risk in Value-Add Investments
- Risk Mitigation
Imagine happily driving into your new job where your advanced skills with up and coming technology will help the company take on new initiatives. In this moment you’re feeling powerful, necessary, and smart.
Only seconds later, as you walk through the door of that prestigious office building, you enter a scene of chaos. You quickly realize you’re witnessing the layoff experience of those with outdated tech skills.
People who have contributed to this market share leader of a company for over 30 years are physically sobbing as they pack their boxes and are escorted to their vehicles. A horrible revolving door feeling washes over you.
If you’d been there like I was, you wouldn’t be able to shake the question, “Could that be me one day?”
This day, those emotions, and that shock stuck with me. If nothing else, the takeaway here is that you should always be learning new skills, pursuing knowledge about new processes and technology, and nurturing your expertise. Don’t shy away from taking classes or attending training to develop and learn new skills.
Periodically, you need to invest some time and energy into curating new skills and refining existing ones. Accept the challenges and breathe some new life into your skills, your career, and your long term plan. Take something outdated and make it valuable, coveted, and useful again.
This is exactly what value-add real estate is all about!
The Basics of Value-Add Real Estate
In the case of single-family homes, the process of buying a run-down property, remodeling it, and then selling it for profit, is commonly referred to as fix-and-flip. Your sweat equity and ability to see a diamond in the rough is rewarded monetarily, and the new owner gets an updated, move-in ready home.
Value-add multifamily real estate deals follow a similar model, but on a massive scale. 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A great value-add property may have peeling paint, outdated appliances, or overgrown landscaping, which all affect the curb appeal and the initial impression that a potential renter will form. Simple, cosmetic upgrades can attract more qualified renters and increase the income the property produces.
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)
Where Value-Add Opportunity Lies
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 I Love Investing in Value-Add Properties
Value-add strategies benefit all parties. When completing renovations on a unit, or house it is providing tenants with a more comfortable home, updated appliances, maybe some attractive community space even. The property becomes more valuable, and that means the ability to increase rental rates, and increase equity. All of this makes investors happy as well!
When you update a property, you will notice a renovated property is more attractive to tenants than an unrenovated one. Let’s learn more about 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 of 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.
Understanding How The Moving Parts Of A Multifamily Value-Add Deal Work Together
Investments are a great opportunity, but no investment is risk-free. But, when you know something will help others, benefit the community, and make investors money at the same time, It becomes a little more attractive.
Value-add investments are more risky than a straightforward cash flowing asset. However, the potential for accelerated distribution values and appreciation values of the property outweigh the risk. Multifamily Syndications in which we’re able to conduct value-add renovations allow for much-needed improvements in apartment communities and create cleaner, safer places for people to live, which makes tenants happier as well!
Investors still have control over how and when renovations are done, and this allows them to have more options to safeguard investment capital and maximize returns. Value-add renovations are similar to a fix-and-flip in residential real estate. You could also compare them to the refurbishment and resale of antique furniture.
The difference is that this “fix-and-flip” work is done on hundreds of units in a relatively short period of time, while taking special care not to disrupt current tenants’ lives and raise the property rent/value methodically. Now that you understand the logistics of how this is done, I’m sure you can see the benefit to investors!