What does value add mean in commercial real estate?
The value of multifamily apartment communities and commercial real estate in general is based on the net income the property produces or can potentially produce.
Value add investing refers to taking an under-performing property (based on net income relative to potential gross income) and operating it more efficiently to realize a higher net income.
As the net income increases, so will the value of the property which creates equity. The property is then sold or refinanced to capitalize on this increased value or to access the newly created equity.
What is a value add strategy?
The value-add strategy refers to buying multifamily real estate with the goal of improving it rather than purchasing an already efficiently run property and maintaining the status quo. If the property is already efficiently operated its’ value will increase over time through organic appreciation.
Value-add investors speed up this appreciation through forced appreciation. Because this value would not have been created without intervention, they are adding value with each management or operational decision that increases the net income of the property.
How do real estate investors add value?
Whatever operational changes are made that increase net operating income are considered value add. The most common way this is achieved is by finding older unrenovated apartment buildings with below market rents. The apartments are renovated and the rents are increased to market value.
This increases the gross potential income and also the net income which adds value to the property. Because net income is the income minus expenses you can also increase net income by decreasing expenses. This may be as simple as negotiating contracts such as insurance or landscaping to lower the cost.
You can also add amenities at the property such as a washer/dryer or a fitness center. These added amenities make the property more valuable to potential renters who will then pay more or stay longer reducing turnover expenses.
Value add investing requires creativity. Investors have to see opportunities that others may overlook. Any decision that will increase income and decrease expenses has the potential to be a value-add. The more of these opportunities an investor finds the more value he or she can add for both investors and residents of the apartment community.
What are the steps to a value-add multifamily investment?
The value add investment strategy involves acquisition, stabilization and disposition. During the acquisition phase a due diligence analysis must be performed to determine if an asset has the potential to be operated more efficiently, the potential for increasing income and possible risks associated with attempts to increase income.
During the due diligence you will verify the current income of the property, and potential increases to expenses such as insurance, urgent repairs, or property taxes. Financing is also secured that is appropriate for the value-add plan or steps you will take to increase net income.
Stabilization is the implementation of the value-add plan. This involves performing the steps of the value add plan, such as renovating apartments, and then leasing them at market value or negotiating contracts.
Many unexpected surprises can occur during this stage such as renovation being delayed or costing more than expected. The value add plan should be adjusted until the property is able to reach and reliably maintain the goal net income.
Disposition of a value-add investment is when the investors get returns for all the hard work and money invested into the value-add apartment community. This is through a sale or refinance for the property.
When is a value add property a good investment?
A value add investment is usually best when the local real estate market of that property is in a recovery stage or expanding. This may be after a recession when the market starts to improve. During this time property values and rent may still be low.
As the economy improves the rents and property values will increase. In addition to this, forced appreciation and value-add investment will increase the property value faster. Attempting this in a declining or peak market is more challenging as it may be difficult to increase rental income or property values when they have already been maxed out.
Value add properties are typically older making the maintenance costs higher. As the market reaches a peak the potential returns for value-add properties and stabilized properties become closer. At this point a stabilized property may be a better long term investment as there is less risk.
What are the benefits of a value-add multifamily investment?
Value add investing provides benefits for both investors and residents of the apartment community. You create a more satisfying environment for residents of the apartment community through value add upgrades.
There is also the benefit to investors of cash flow, appreciation, principal paydown and tax benefits. Forced appreciation allows you to get a quick increase in value like a fix and flip investor at disposition while you are able to make cashflow like a long term buy and hold investor during the stabilization phase.
Investing in multifamily via syndications also allows you to have the option of gaining all of these benefits passively.
What are the risks of value-add apartment investing?
The risk of value-add investing is not being able to complete the value-add plan. Due diligence prepares you for the stabilization of a value-add investment and allows you to fine tune you value add plan. If the prior owner has a value add plan you may benefit from continuing it as you have proof of concept.
If there is no prior proven value add plan you will be testing the market to see if your value add plan will be successful. There is the risk that your renovations will take longer than expected due to unexpected permits, deferred maintenance being greater than expected or other unforeseen costs. You may also be unsuccessful in finding cheaper vendors or renegotiating contracts to reduce operating expenses.
There is also the risk that the projected market rent of the apartment may be higher than the true market value. Because the majority of income a multifamily property generates is from rental income, not being able to achieve these projected rents would have a major impact on your ability to increase net income.
These risks are offset by thorough due diligence, knowing your market well, consulting other investors, property managers and real estate professionals within the market. The greater the number of potential value add opportunities the property has the lower the risk will be. This gives you cushion to still increase the property value and income, even if you are not able to reach the maximum amount.
Sometimes only partially optimizing a property is sufficient as you can then sell to another value add investor with a proof of concept value add plan. This decreases the risk for the incoming investor and makes the property more valuable to them.
How is value add investing different from core or opportunistic investing?
A core apartment investment is a stabilized apartment community in a stable submarket. These properties are typically newer with reliable income histories. This leaves less opportunity to force net income but decreases risk as the acquiring investor just has to maintain status quo.
Opportunistic investments are like value-add investments but more the properties are distressed requiring more intense and higher risk value add plans.
Is value-add investing still worth it?
While it is not risk free, value add investing offers a balanced mix of risk and reward relative to core and opportunistic investing strategies. As the real estate market is cyclical, these investments are harder to find as the market reaches a peak but will reappear. If this is a strategy that you are interested in, you are not too late or too early, you just may have to be more creative.
How do you find value-add multifamily investments?
Most value-add apartment investments are found through commercial real estate brokers, you can also find them through networking and mailing campaigns. The most efficient use of your time may be through brokers who are already marketing and campaigning to find these deals.
You can also find these deals by being more creative, and using advantages available to you that other investors may not have such as such as being able to source cheaper construction materials.
Should you invest in value add real estate?
Value-add real estate investing is one strategy for multifamily apartment community investment. Depending on your risk tolerance, and investment timeline it can be a profitable investment.