Written by Aly Hashim
You may have heard the term “value-add investment” before when referring to real estate, but what exactly is this concept? How does it work? What are some of the tools you need to be successful?
Value-add investments are an innovative process that combines the different elements of arts and science. In simple terms, value-add investments are properties that require improvements in order to increase its overall value. These plans typically target properties that have in-place cash flow, but over time seek to increase that cash flow by making improvements to reposition the property, thereby increasing revenues or reducing operating expenses. In order to maximize this opportunity, a plan to raise rents or reduce expenses must be in play to make up for capital investment in the property itself.
There are many properties that are in distressed or rundown conditions because many owners don’t have enough capital to make these improvements or have reached a point of obsolescence to where they don’t care to improve the quality of their properties. Much of the success behind value-add investing requires a vision along with creativity in order to truly uncover and understand the potential an asset could contain. The investor must also have a strong plan and discipline to successfully carry out their investment goals which maximizes results. Although this “value-add” concept has been around for a very long time, value-add investments have been dominating the multifamily markets as it is clear that there is a huge trend reflecting the idea that residents are willing to pay higher rents in order to improve their personal living experiences.
Many times, the capital improvement made to the property is of a size and amount that the owners would choose to capitalize the improvement from an accounting standpoint. However, it is not uncommon for the owner to actually expense the improvement in an effort to secure the tax write off in the current period. In the event the property owner elects to expense the improvements, they will generally see a reduction in net operating income for the short-run, yet will see a material increase once the improvement are completed. The following is a visual example of such an expense treatment:
These charts are supposed to show how NOI may expectedly drop, but then recovers into a state of stability and smooth growth. This leads us to believe that this goes hand in hand with the unit renovation schedule.
Value-Add Categories of Opportunity
While there is a plethora of opportunities that “add value” to multifamily investment properties, each strategy being dependent on the market or property, they are usually focused in one of three different categories: operational enhancements, capital improvements and total repositioning.
The first category, operational enhancements, are usually the most common in under-managed properties. Oftentimes, they also require little or nominal capital investment. Enhancements to property management can drive some of the quickest improvements in net operating income. Some examples of operational enhancements include reducing expenses, raising rents to meet market level, and enforcing fee income policies, such as pet fees or late fees.
Capital improvements can be extremely crucial as they increase the attractiveness image, curb-appeal and overall desirability of the property. Although this potential revenue source can take place in many shapes or forms, the most impactful and measurable are properties that undergo interior improvements. An example of a capital improvement can be kitchen or bathroom upgrades that can increase the appeal and “rental rates” of an older or vintage apartment property.
The final category is total repositioning. This strategy evolves around the idea of transforming a community’s marketability to appeal to more affluent residents. This category is especially unique as it combines aspects of the other two categories, operational enhancements and capital improvements. To give an example of total repositioning, you can utilize the expiration of a Land Use Restriction Agreements (LURA). When a LURA related to an affordable housing property expires, rent restrictions usually fade away or altogether are eliminated, thereby allowing the property owner to increase the rents to standard market levels. This can trigger resident turnover, which ultimately leads to higher-income clientele, elevated property valuations and overall enhanced identity of the property.
Finding Success in Value-Add Properties
When looking to be successful with a value-add investment, it is important to choose renovation opportunities that potentially have the most embedded upside profit potential. Properties that are viewed as older, uglier, in disrepair, mismanaged and generally unsightly have the potential to be more profitable. In other words, you have a greater incremental increase in value when taking a D- property to a C, that a C to a C+ property.
It is important to find a property that may not be the most aesthetically pleasing, but has no structural issues. Then, you must rehab it and reposition it within the micro-location and market in which it serves. If the specific property is substantially more unattractive than other properties in the market, and there is significant room to raise the rents once the property is renovated, then that is worth investigating further. In simple terms, this strategy can best be defined as “ugly with good bones”.
Instead of taking the rent roll of the entire property and forecasting how much each individual unit will require in terms of renovations to predict the available rent premium, there is a smarter and more efficient way to execute this process. The whole idea is that a property owner has a bunch of apartment units that produce an aggregate cash flow. Based on this approach, this bundle of units can be viewed on a hypothetical average basis, that commands a certain average rent. Because all the units in an apartment start from a similar level and end up at the same state, it makes more sense to utilize an average renovation budget per unit, along with an average monthly rent premium, when determining the cost-benefit analysis.
Although most people have their own internally-generated due diligence checklist when investing in value-add properties, the following is a quick and high-level strategic approach in creating strategic value: