Commercial Value-Add Real Estate: How Do They Work?
When my wife and I were in single-family fix-and-flips, we often found ourselves inside some very ugly houses. Certain pieces of real estate needed so much work I wondered why someone would want to put in so much time, money, and effort to fix something up when they could just buy new.
But buying new is not always an option because there are already pre-existing properties in the most prime locations. Real estate is always about location, location, and location. This is something that can not be changed, while other aspects of the property are malleable.
When I started investing passively in real estate, I quickly understood that the same opportunity in single-family homes lies in older apartment buildings as well. In either single-family or multi-family, these “tired” assets are often overlooked as owners fear renovation and maintenance headaches.
However, with my previous experience in single-family fix-and-flips, I am able to look past the rough appearance. My eyes tend to notice the “strong bones” of a property. I’m easily able to pick out unique features and visualize how a few thousand dollars of work could render hundreds of thousands of dollars in value.
I’m sure you’ve seen the property-flipping shows on TV where they put in the sweat equity to pull a giant profit. Adding longevity, value, and appeal to these properties allows them drive appreciation upward, which often causes them to sell quickly.
This idea is the essence of value-add, a commonly used strategy in commercial real estate investing.
The Basics of Value-Add Real Estate
In the case of single-family homes, 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.
An excellent value-add property may have peeling paint, outdated appliances, or overgrown landscaping, affecting the curb appeal and the initial impression of a potential renter. 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)
Value-Add Examples
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
Landscaping
Dog parks
Gyms
Pools
Clubhouse
Playgrounds
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 the renovation schedule and logistics aren’t as intuitive for 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. 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 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
When done well, value-add strategies benefit all parties involved. Through renovations, I provide tenants with a more aesthetically pleasing property with updated appliances and a more attractive community space. Doing so makes the property 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 and 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 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 property’s value, and doing such improvements carries 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 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)
Risk Mitigation
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.
No Reward Without Risk
We all know no investment is risk-free. Despite the risks, investors provide the community with new or updated attractive housing options, which in turn provides investors with a sizable return.
When investor capital is leveraged properly, a value-add investment allows for attractive and practical improvements in apartment communities, creating a cleaner and safer place for people to call home. Tenants and the community become happier, and the value of the area increases.
Value-add properties are enticing since instead of relying on the market appreciation alone, investors have more control over how and when renovations are performed. Value-add real estate gives them more options regarding safeguarding capital and maximizing their returns.
