What Is Value Add Property?
Corrective action is required to fully realize the value of an investment property. One of the four key risk profiles of commercial real estate investment properties is described as value-add.
Value-add properties have a higher risk profile and possible returns than core and core-plus properties, but less risk and possible returns than opportunistic properties. To attract new tenants and keep existing tenants, properties in this risk profile often require significant capital improvements and/or marketing initiatives.
Income and appreciation are expected to make up the majority of total returns from value-add assets. The exact distribution of returns, however, is dependent on the degree of value-add activity, which ranges from “light” value-add (in which returns are more heavily distributed to income than appreciation) to “ heavy” or “deep” value-add (in which total returns would be more skewed toward appreciation than income). Short- to medium-term holding durations are common for value-add properties.
What Is Value Add Property in Simple Terms?
It is a real estate property that needs some work to raise its worth. These types of investment properties can become rundown due to a lack of funds or just neglect, distressed or value adds properties can be purchased for a fraction of their market worth and improved structurally, physically, and operationally. This will aid in the recruitment of new tenants, the reduction of vacancy rates, and the increase in rentals.
Value Add Property: It is a real estate property that needs some work to raise its worth.
Locating the Ideal/right Value-Added Investment Property
The “top-down” component of the strategy is focusing on the suitable market to carry out value-add investing, but the “bottom-up” component is as important. On an asset-by-asset basis doing property-level screening and discerning acquisition opportunities. Firms can screen prospects by seeking for inexpensive, underperforming assets in desirable places. Each value-add investor should consider the property’s size, age, layout, amenities, and location, depending on their preferences and real estate knowledge.
Choosing the ideal value-added acquisition opportunity isn’t exactly plucking low-hanging fruit. While many properties may be eligible for this technique just based on their worth or condition, some may be too costly to repair or functionally obsolete. What appears to be a “deep-value” opportunity could easily be a “value trap.”
As a result, the choice here is between prospective revenue and renovation risk. Well-maintained and stable, typical Class-A buildings in city centers often have minimal room for rent increase. These newly built assets are also more vulnerable to new construction, since they compete directly with new supply entering the market, making it difficult to maintain occupancy and rent increases, especially in a growing, over-supplied market. Class-Cs, on the other hand, charge below-market rents, but with fewer tenant turnover, the capacity of investors to raise rents is constrained by potential tenants’ willingness to pay. Given that the key discount factors on these Class-C multifamily buildings are invariable property qualities like layout and location, apartment improvements alone will not be sufficient to attract a new group of tenants ready to pay a high enough rent to cover the renovation costs.
With Class-B assets, value-add investors can find a happy medium between cost and prospective value. Capitalization rates for Class-B value-add investment properties are higher than those for core, Class-A assets. In opposed to Class-A assets, Class-B assets have greater natural room to raise rents and lower operating expenses, making them less reliant on cap rate reduction. Class-B multifamily investors can offer tenants high-quality housing options without paying Class-A rent by renovating each unit, common area, and property exteriors, justifying rent increases and attracting potential tenant demand from those looking for high-quality housing without breaking the bank.
Following preliminary screening and identification of acquisition targets, the sponsor must do rigorous due diligence and get a full grasp of a property’s physical condition. Undiscovered structural defects and other hidden difficulties can deviate from the original underwriting and put the project’s budget in jeopardy. To lessen investor exposure to cost overruns and delayed stabilization, the sponsor must anticipate any surprises and account for potential refurbishment issues ahead to acquisition in the underwriting. This is the stage of value-add investing when selecting a manager is most vital.
Passive investors should choose assets carefully depending on the sponsor’s real estate experience. Investors must consider whether the sponsor is competent of conducting complete due diligence, completely assessing the property condition, and making the appropriate asset selection judgment call.
In the middle market, where assets are often inefficiently priced, passive investors must rely on institutional sponsors who can identify the right acquisition opportunity and execute it properly using their deep experience, negotiating power, information advantage, development expertise, and brokerage connections. We at MarketSpace Capital like to work with seasoned sponsors. We conduct in-house sponsor-level and transaction-level due diligence to enable investors wishing to profit from value-add investing opportunities with an additional degree of security.
Finding the Correct Market for Value-Add Investing
Value-add investors must not only identify the right market – one where acquisitions can be made at a reasonable discount today – but also forecast the market outlook and select a market where conditions are likely to stay favorable upon exit. Buying an asset at a big discount won’t help you much if the final sell-out value doesn’t cover the acquisition cost and refurbishment costs.
Due to a significant inflow of capital from institutional players, primary markets where value-add investing has previously succeeded are now overvalued. Rent growth in these key markets is being slowed, which may make it difficult for value-add investors to raise rent when the renovation is completed. Value-add multifamily investors should concentrate on markets with opportunities for rent increase, little competition, strong economic fundamentals, and steady demand for multifamily housing.
Fortunately, a good middle-market value-add investment thesis may still be found in specific neighborhoods in secondary and tertiary markets. These sub-markets are close to the metropolitan districts of rapidly growing secondary and tertiary cities, which are seeing extraordinary expansion in technology, healthcare, finance, and other developing industries.
These towns, such as Austin, Texas; Nashville, Tennessee; and Raleigh-Durham, North Carolina have successfully unlocked economic growth potential from a highly educated workforce and other demographic advantages but have also seen cost of living rise faster than average income growth. Rent increase fueled by an overheated multifamily market and a scarcity of rental property has encouraged many young and lower-income employees to relocate from urban centers to more inexpensive submarkets surrounding downtown in these markets. These submarkets, which are five to ten miles from the city’s core business center, benefit from the city’s strong economic trends and job growth, while also providing investors with a low entry cost and opportunities for rent growth.